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Preferred Stocks

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Preferred Stocks

Preferred stocks are a hybrid between common stocks and bonds.(Credit: Getty Images)

Definition: Preferred stocks are another way for a company to raise capital for its growth. They are called preferred because, in the event a company goes bankrupt, preferred stockholders will get paid back before common stockholders. However, they get paid after bondholders, and usually there is nothing left of the company's value by then.

Preferred Stocks vs Common Stocks

Preferred stocks are like common stocks, in that they are traded through brokerage firms, and the price of each share rises and falls depending on the perceived value of the company.

However, unlike stocks but like bonds, preferreds pay the stockholder a fixed, agreed-upon dividend at regular intervals. Common stocks may pay dividends, but they vary depending on how profitable the company is. Preferred stocks are also like bonds in that, if they are held until maturity (typically 30-40 years), stockholders will get all of their initial investments back. However, the company reserves the right to recall preferred stocks before maturity, paying the issue price. Like bonds, and unlike stocks, preferred stocks do not confer any voting rights.

Why Do Companies Issue Preferred Stock?

Preferred stocks have one advantage over bonds, in that the dividends can be suspended by the vote of the board without risk of being sued for default. If the company doesn't pay the interest on its bonds, it will be in default.

Preferreds are also used when selling ownership of the company to another company. For one thing, companies get a tax write-off on the dividend income of preferred stock. In fact, they don't have to pay taxes on the first 80% of income received from dividends. Unfortunately, individual investors don't get that same tax advantage. Second, companies can more easily sell preferred stock than common stock. That's because owners know they will be paid back before the owners of common stock will.

This advantage was why the U.S. Treasury bought shares of preferred stock in the banks as part of TARP. It wanted to make sure banks were capitalized, and wouldn't go bankrupt. However, it also wanted to protect the government, and taxpayers, by being a part-owner of the company and getting paid back before the common shareholders if the banks got into trouble after all.

However, preferred stock is usually only issued as a last resort, after companies have gotten all they can from issuing common stock and bonds. That's because preferred stock is more expensive than bonds. The dividends paid by preferred stock comes from the company's after-tax profits. These expenses are not deductible. The interest paid on bonds is tax-deductible, and so is cheaper for the company. However, if the company doesn't want to issue more stocks or bonds, they do have certain advantages. The dividends can be suspended, if necessary. They are also used in mergers, because the preferred shareholders will get paid before common shareholders, but after bondholders. (Source: Motley Fool, The Power of Preferred Stocks, April 24, 2001)

Convertible Preferred Stocks

Like the names suggests, convertible preferred stocks have the option to be converted into common stock at some point in the future. What determines when this happens? Three things:
  1. The corporation's Board of Directors may vote for a conversion.
  2. You might decide to convert. You would only exercise this option of the price of the common stock is more than net present value of your preferreds. The net present value includes the expected dividend payments and the price you would receive when the life of the preferred is over.
  3. The stock might have automatically convert on a pre-determined date.
(Source: Joshua Kennon, About.com Guide to Beginning Investing, Convertible Preferred Stock)

Cumulative Preferred Stocks

One of the advantages, for companies, of issuing preferred stock over bonds is that they can vote to suspend a dividend payment when earnings aren't good, and not risk accusations of default. If you hold a cumulative preferred stock, however, the company must make up all the missed dividend payments when times are good again. In fact, they must do this before they can make any dividend payments to common stockholders. Preferred stocks without this advantage are called non-cumulative stocks.(Source: The Many Flavors of Preferred Stock)

Redeemable Preferred Stock

Also known as callable preferred stock. The company reserves the right to redeem or call in the preferred stock at any time after a specific date. The option usually describes the price the company will pay for the stock. The redeemable date is usually not for a few years. These stocks typically pay a higher dividend to compensate for the additional redemption risk. Why? The company would only call for redemption if interest rates are lower, and can more cheaply issue new preferreds and pay a lower dividend. This means lower profit for the investor. (Source: Toolbox for Finance, Redeemable Preferred Stock) Article updated August 30, 2013
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