Preferred stock (or preferred share) is an equity security that ranks between debt securities and common stock. It usually does not has voting rights but has priority over ordinary shares in receiving dividends and liquidated assets.
In the financial statements, the company classifies preferred share either as financial equities or liabilities depending on their characteristics. For example, preferred shares with mandatory redemption are categorized as financial liabilities, while perpetual and nonredeemable preferred shares are classified as equity.
As a hybrid security
Preferred stock is called hybrid security because it has the characteristics of a combination of ordinary shares (or common stock) and bonds. Ordinary shares do not receive a dividend regularly, and their price depends on the growth rate of dividends (higher dividend is a potential upside driver for ordinary stock price).
Meanwhile, preferred shareholders receive dividends regularly and at a fixed amount, similar to debt securities coupons such as bonds. For example, if the nominal value of shares is Rp1,000, and the dividend is 10%, the company must pay Rp100 per year to preferred shareholders.
The difference between preferred shares, bonds, and ordinary shares
In general, the risk level of preferred shares is between ordinary shares and bonds. Common stock has the highest risk, and bonds have the lowest risk.
Bonds are usually the safest way to invest in public companies because, legally, shareholders must receive bond interest payments before the company could pay a dividend. If the company is in a liquidation, the bondholders will be paid off first if there is money left.
Unlike common stock, preferred stock does not carry voting rights. Furthermore, it also has less potential for price appreciation than common stock. Some preferred stocks are convertibles, which means they can be exchanged into some common stock in certain circumstances.
Even though it does not have voting rights, the preferred share is preferable because it has priority over the company’s earnings, which means that the holder gets a dividend before the ordinary shareholders. Most investors are like it because it offers regular dividend payments without long maturity dates such as bonds or exposure to market fluctuations like ordinary shares. And if the company bankrupts, preferred shareholders receive the company’s assets before ordinary shareholders.
For issuing companies, preferred stocks and bonds are an easy way to raise money without issuing more expensive common shares. Investors like preferred stocks because this type of stock offers higher yields than corporate bonds.
Types of preferred stock
The five common types of preferred stocks are:
- Convertible preferred stock
- Participating preferred stock
- Cumulative preferred stock
- Callable preferred stock
- Adjustable-rate preferred stock
Convertible preferred share
Convertible preferred share has a conversion feature into the company’s ordinary shares. Because it has a conversion option, holders have the potential to benefit from an appreciation in the price of common shares. For the record, after we convert it into ordinary shares, we cannot convert back to preferred shares.
Participating preferred share
It is a type of preferred share in which shareholders receive dividends before they are paid to ordinary shareholders, and are preferred over ordinary shares in the event of a liquidation.
The holder also receives an additional dividend, usually paid if the amount of dividends received by ordinary shareholders exceeds the specified per-share amount.
Participating preferred shares are mainly issued by new companies that require cash infusions. This type of stock can also be issued in response to a hostile takeover offer as part of a poison pill strategy.
Cumulative preferred share
The cumulative preferred share pays regular dividends, usually quarterly. When the company does not pay, the amount of dividend owed will accumulate and must be paid before issuing dividends to preferred shareholders. Not all preferred stocks have this feature, some of which are non-cumulative.
Callable preferred share
Callable preferred share (also popularly known as redeemable preferred stock) enables the company to call it at a specific date and a particular redemption price in the future. The redemption price may be slightly higher or equal to the original issue price. It pays a dividend, like other forms of equity, but can also be repurchased by the issuer, which is a characteristic of debt securities.
Because it has a call feature, this type of preferred stock is more profitable for issuers. Preferred shareholders do not have the option to reject the call. Hence, redemption is at the discretion of the issuing company.
Adjustable-rate preferred share
Adjustable-rate preferred share is a type of preferred share that pays dividends varies because it is linked to a specified benchmark, for example, interest on T-bill. Determination of the level of adjustment is stated in the prospectus and may have a maximum and minimum rate. This adjustment feature makes it more stable than other preferred shares.
Effects of changes in interest rates to preferred stock
The significant risk of owning preferred shares is that they are sensitive to interest rates. Price of preferred stocks rise when interest rates fall, and prices fall when interest rates rise.
Companies can use the call option on preferred stocks when the dividends are too high compared to market interest rates. After being redeemed, they often reissue new preferred shares with lower dividend payments.
Advantages and disadvantages of preferred stock
Investors like preferred shares because they pay higher and more regular dividends than the common stock. Dividend yields are also usually higher than bond yields because debt costs are tax-deductible, whereas preferred share costs are not tax-deductible.
But indeed, a higher yield of preferred shares carry a higher risk than bonds. Also, price appreciation is relatively not as high as ordinary shares that have unlimited capital gain potential.
Fixed dividends also make preferred stocks sensitive to changes in interest rates. When interest rates rise, their price decline. That is increasingly unprofitable when companies use the call option at any time in the future.
Preferred shares also do not provide voting rights. That means the holder does not influence critical corporate issues, such as mergers or directors elections.