What Is Preferred Stock?

Summary

Preferred stock is a class of company equity that combines characteristics of both stocks and bonds: it typically pays a fixed dividend and gives holders priority over common stockholders for dividend payments and during liquidation. While it represents ownership in a company, its fixed-income features make it behave differently from common shares. Understanding how preferred stock works, what types exist, and what risks it carries can help self-directed investors evaluate whether it belongs in their broader research and portfolio planning.

What Is Preferred Stock?

Simple Definition

Preferred stock is a class of company equity that typically offers dividend priority over common stock. When a company declares dividends, preferred stockholders are generally paid before common stockholders receive anything. This priority, combined with a fixed or stated dividend rate, is what gives preferred stock its bond-like income characteristics.

Despite those income features, preferred stock is still equity, not debt. It represents ownership in a company, and holders bear the risks that come with equity ownership, including the possibility of losing principal. According to the SEC Investor.gov guide to stocks, preferred stock does not carry the same contractual repayment obligations as bonds. If a company struggles financially, preferred dividends can be reduced or suspended entirely.

Preferred stock ranks between common stock and debt in a company's capital structure:

Bonds and creditors (highest priority)
Preferred stockholders (middle priority)
Common stockholders (lowest priority)

This positioning means preferred stockholders have a stronger claim than common shareholders but remain subordinate to bondholders and other creditors if a company is liquidated.

Why Companies Issue Preferred Stock

Companies issue preferred stock for several strategic reasons. It allows them to raise capital without taking on traditional debt, which can help manage balance sheet ratios. It also lets companies attract income-oriented investors by offering more predictable dividend features.

Because preferred stock typically carries limited or no voting rights, issuing it lets companies bring in new capital without diluting the voting control of existing common shareholders. This is common in venture capital and startup financing, where companies may issue multiple series of preferred stock (Series A, B, C) to provide investors with downside protection through liquidation preferences while preserving founder governance.

Banks, utilities, and financial institutions frequently issue preferred shares because their business models align well with the income-oriented investor base that preferred stock attracts.

Key reasons companies issue preferred stock:

Raise capital without increasing debt obligations
Preserve voting control for existing shareholders
Attract income-focused investors with predictable dividends
Provide downside protection for venture and private equity investors

How Does Preferred Stock Work?

Dividends

Preferred stock dividends are typically set at a fixed or stated rate, often expressed as a percentage of the stock's par value. This fixed dividend is one of the primary features that distinguishes preferred stock from common stock, where dividends are discretionary and can vary widely from quarter to quarter.

Dividend priority means that preferred stockholders are paid before common stockholders when dividends are declared. However, preferred dividends are not guaranteed in the same way bond interest payments are. If a company faces financial difficulty, it may suspend preferred dividend payments. Whether those missed payments accumulate depends on the specific terms of the preferred stock issue, a distinction covered in more detail in the types section below.

Par Value and Yield

Par value is the face value assigned to a share of preferred stock when it is issued. It is the baseline number used to calculate the fixed dividend. For example, a preferred share with a $25 par value and a 6% dividend rate would pay $1.50 per year in dividends.

On the open market, preferred stock can trade above or below its par value. When the market price changes, the effective yield an investor receives also changes. If the price rises above par, the yield drops below the stated rate. If the price falls below par, the yield rises. This relationship between price and yield is similar to how bonds behave and is an important concept for anyone studying income-oriented securities.

Liquidation Preference

A liquidation preference is a contractual right that entitles preferred stockholders to receive a specified amount of a company's assets before any distributions are made to common stockholders in the event of a liquidation, dissolution, or sale.

If a company is dissolved, the order of payment follows a strict hierarchy:

Secured creditors and bondholders
Preferred shareholders
Common shareholders

This means preferred stockholders have a stronger claim than common shareholders, but they are still behind debt holders. In a severe bankruptcy, it is possible for preferred stockholders to receive little or nothing if the company's debts exceed its remaining assets.

Preferred Stock vs. Common Stock: What's the Difference?

Preferred stock and common stock are both forms of equity ownership, but they differ significantly in dividend treatment, voting rights, capital appreciation potential, and claim priority during liquidation. According to the FINRA stock overview, preferred stockholders have priority over common stockholders for a company's income, but they typically give up voting rights in exchange.

Preferred Vs Common Stock

The Fidelity preferred stock explainer notes that preferred shares are often in shorter supply than common shares and are traded on exchanges just like common stock, but their price behavior tends to be more closely tied to interest rate movements than to company earnings growth.

Preferred stock may appeal to investors studying income-oriented securities and dividend priority. Common stock may appeal to those focused on ownership, voting rights, and long-term growth potential. The trade-off is straightforward: preferred stockholders accept limited voting power and capped growth in exchange for more predictable income and higher priority in dividend payments and liquidation.

Is Preferred Stock Better Than Common Stock?

It Depends on the Feature Being Compared

There is no universal answer to whether preferred stock or common stock is "better." The comparison depends entirely on what an investor values most.

For dividend priority: Preferred stock has an advantage. Preferred dividends are typically paid before common dividends.
For voting rights: Common stock usually has the advantage. Most preferred stock carries no voting power.
For growth potential: Common stock often offers more upside. Preferred stock prices tend to be more stable but also more capped.
For capital structure priority: Preferred stock ranks above common stock but below debt. In a liquidation, preferred holders are paid before common holders.

The right comparison depends on income needs, growth expectations, risk tolerance, and the specific terms of the security in question. Neither type of stock is inherently superior in all situations.

What Are the Main Types of Preferred Stock?

Preferred stock may be issued in multiple classes or series, each carrying different terms. Understanding these variations is essential before evaluating any preferred stock investment. The Investor.gov glossary provides definitions for many of these related terms, including convertible securities.

Cumulative Preferred Stock

Cumulative preferred stock is a type of preferred share where any unpaid or skipped dividends accumulate as arrears and must be paid in full before any dividends can be distributed to common stockholders. This feature provides an extra layer of income protection for investors. If a company misses several quarters of preferred dividends, the entire accumulated amount must be made whole before common shareholders see a penny.

Non-Cumulative Preferred Stock

With non-cumulative preferred stock, missed dividends are lost forever. The investor has no right to recover skipped payments. This distinction is one of the most important terms for income-focused investors to evaluate:

Cumulative: Missed dividends accrue and must be paid before common dividends resume.
Non-cumulative: Missed dividends are forfeited permanently.

Convertible Preferred Stock

Convertible preferred stock includes the right to convert into a specified number of common shares, usually at the holder's option and under conditions defined in the offering terms, such as an IPO or acquisition event. Venture capital investors often receive preferred shares with conversion rights, while founders and employees receive common stock. Convertibility gives investors the option to participate in the upside if the company succeeds while retaining downside protection through liquidation preferences.

Callable and Participating Preferred Stock

Callable preferred stock gives the issuing company the right to redeem or buy back the shares at a predetermined price after a specified date. This feature benefits the issuer, particularly when interest rates decline, but can cap the investor's long-term price appreciation. Many preferred issues include call features, which is an important consideration for anyone evaluating long-term holding potential.

Participating preferred stock entitles holders to receive additional payments beyond the stated dividend under certain conditions, such as when common stockholders receive dividends above a specified threshold.

Callable: Issuer can redeem shares early, which limits upside for investors.
Participating: Holders may receive extra dividends beyond the fixed rate in certain scenarios.

What Are the Advantages of Preferred Stock?

Potential Income Priority

Preferred dividends generally come before common dividends. For investors focused on income investing, this priority can make preferred stock an appealing area of study, particularly during periods of market uncertainty when common stock dividends may be reduced.

Higher Claim Than Common Stock

In a liquidation scenario, preferred shareholders rank ahead of common shareholders. While this does not eliminate risk, it does provide a stronger position in the capital structure than common equity alone.

Potentially Lower Volatility Than Common Stock

Because preferred stock often pays a fixed dividend, its price behavior can differ from common stock. It tends to be less volatile in response to company-specific earnings news, though it can still fluctuate meaningfully in response to interest rate changes and broader market conditions. Lower volatility does not mean safe or stable, and preferred stock can still lose value.

What Are the Risks and Downsides of Preferred Stock?

Interest Rate Risk

Preferred stock prices can decline when interest rates rise, similar to bonds. According to the iShares preferred stock ETF example, rising interest rates may cause the value of preferred stock investments to decline significantly. During the rising rate environment of 2022, the iShares Preferred and Income Securities ETF (PFF) experienced a calendar year NAV return of -18.37%.

Credit and Issuer Risk

A financially stressed company may suspend dividends or see its preferred stock decline in value. Preferred shareholders are junior to bondholders in bankruptcy, meaning they could lose their entire investment if the issuer's debts exceed its assets.

Limited Voting Rights

Preferred shareholders often have little or no say in corporate governance. This is a meaningful trade-off for investors who want influence over company decisions.

Call Risk

If callable preferred shares are redeemed by the issuer, investors may have to reinvest the proceeds at lower yields, particularly if rates have fallen since the original purchase.

Lower Growth Potential

Preferred stock may not benefit from company growth as much as common stock. Its price is more closely tied to interest rates and dividend stability than to earnings growth or market momentum.

How Are Preferred Stock Dividends Taxed?

Ordinary vs. Qualified Dividends

Some preferred stock dividends may qualify for favorable federal tax treatment as qualified dividends, which are taxed at long-term capital gains rates (0%, 15%, or 20%) rather than higher ordinary income tax rates. However, qualification depends on the specific security, the investor's holding period, the account type, and individual circumstances.

According to IRS Publication 550, preferred stock has specific holding period requirements for dividends to qualify for favorable treatment. For preferred stock with dividends attributable to periods totaling more than 366 days, investors must hold the stock for more than 90 days during the 181-day period beginning 90 days before the ex-dividend date.

This section is for educational purposes only and does not constitute tax advice. Consult a qualified tax professional for guidance on your specific situation.

Where Does Preferred Stock Fit in a Portfolio?

Role in Diversification Discussions

Preferred stock is often studied alongside dividend-paying stocks, bonds, and income-focused funds as part of a broader portfolio diversification discussion. It may be accessed through individual preferred shares or through preferred stock ETFs, which bundle hundreds of individual preferred issues into a single fund.

For example, the iShares Preferred and Income Securities ETF (PFF) held 456 individual preferred securities as of its most recent reporting period, with a 30-day SEC yield of 6.28% and heavy concentration in the financial sector (61.67% of holdings). These characteristics illustrate how preferred stock exposure tends to cluster in specific industries.

When evaluating preferred stock or any investment, it is important to review issuer terms, risks, fees, and tax treatment. No single asset class is appropriate for every investor or every goal.

Bottom Line: Preferred Stock vs. Common Stock

Preferred stock generally offers dividend priority and a higher claim than common stock in a company's capital structure. Common stock generally offers voting rights and greater potential for long-term capital appreciation. Both involve risk, and neither guarantees income, gains, or principal protection.

The distinction between the two comes down to trade-offs. Preferred stock trades voting power and growth potential for more predictable income and a stronger position in the payment hierarchy. Common stock trades income stability for the possibility of greater long-term returns and a voice in corporate governance.

Frequently Asked Questions

What is preferred stock in simple terms?

Preferred stock is a class of company ownership that usually pays dividends before common stock and has a higher claim on assets than common stock if the company liquidates. It is often described as a hybrid security because it combines features of both stocks and bonds.

How does preferred stock differ from common stock?

Preferred stock usually has dividend priority and limited voting rights. Common stock usually has voting rights and more potential for capital appreciation, but it is last in line for dividends and liquidation claims.

Is it better to buy preferred or common stock?

Neither is automatically better. Preferred stock and common stock serve different purposes, and the right comparison depends on income needs, growth expectations, voting rights, risk tolerance, and the specific company and security terms.

What is the downside of buying preferred stock?

Preferred stock can lose value, may have limited voting rights, can be sensitive to interest rate changes, and may have dividends suspended depending on the issuer and security terms. Callable preferred stock can also be redeemed by the issuer at potentially inconvenient times.

Why doesn't everyone buy preferred stock?

Preferred stock often has less growth potential than common stock and usually does not provide the same voting rights. It also carries issuer risk, interest rate risk, call risk, and liquidity risk.

Do preferred shareholders get paid before common shareholders?

Generally, yes. Preferred shareholders typically receive dividends before common shareholders and rank ahead of common shareholders in liquidation, but they rank behind bondholders and other creditors.

Are preferred stock dividends guaranteed?

No. Preferred stock dividends are typically more predictable than common stock dividends, but a company can suspend preferred dividend payments if it faces financial difficulty. With non-cumulative preferred stock, missed dividends are not recoverable.

Can preferred stock go up in price?

Yes. Preferred stock can trade above or below its par value on the open market. Its price is influenced by interest rate movements, the issuer's financial health, and overall investor demand.

Who usually buys preferred stock?

Preferred stock is often purchased by income-focused investors who prioritize regular dividend payments and more predictable income over capital appreciation and growth potential.

Categories:

Finance

Disclaimer

This article is for informational purposes only and is not intended to constitute investment or tax advice in any way or constitute an offer to buy or sell any digital asset, cryptocurrency, or security or to participate in any investment strategy.

iTrustCapital is a fintech software platform for alternative assets. TrustCapital is not an exchange, funding portal, custodian, trust company, licensed broker, dealer, broker-dealer, investment advisor, investment manager, or adviser in the United States or elsewhere. iTrustCapital is not affiliated with and does not endorse any particular digital asset, precious metal or investment strategy.

Investing in any digital asset or cryptocurrency (including meme coins) carries significant risks due to their speculative and highly volatile nature. Past performance is not an indication of future results. No investment is completely risk-free, and every investment carries the potential for losing some or all of the principal amount invested. Digital assets and cryptocurrencies are not legal tender backed by the United States government, nor is it subject to Federal Deposit Insurance Corporation (“FDIC”) insurance or protections. Clients do not receive a choice of custody partner.

Investors assume the risk of all purchase and sale decisions. iTrustCapital makes no guarantee or representation regarding investors’ ability to profit from any transaction or the tax implications of any transaction. iTrustCapital does not provide legal, investment or tax advice. Conduct your own research and consult with a qualified legal, investment, or tax professional to assess your own risk tolerance prior to investing.

iTrustCapital makes no representation or warranty as to the accuracy or completeness of this information and does not have any liability for any representations (expressed or implied) or omissions from the information contained herein. iTrustCapital disclaims any and all liability to any party for any direct, indirect, implied, punitive, special, incidental or other consequential damages arising directly or indirectly from any use of this information, which is provided as is, without warranties.