The Benefits and Drawbacks of Preferred Stock Investing
Some companies issue two types of stock: common and preferred stock. While each offers a portion of ownership in the company, there are significant differences between the two. Preferred stock is often seen as a hybrid instrument; a mix between a stock and a bond. Although preferred stock is an equity security, it has many characteristics that are similar to a debt instrument.
Why Companies Offer Preferred Stock
For the issuing company, preferred stock can be easier to market than common stock as most holders of preferred shares tend to be bond institutional investors. This is due to tax law that enables U.S. corporations that pay income taxes to exclude a large portion (70%) of their dividend income from taxable income. Additionally, if cash flow problems arise for the issuing company, they may suspend dividend payments to preferred shareholders.
Even so, the amount of preferred stock issued by a company usually represents a very small percentage of its funding (compared to common stock and debt).
Unique Features of Preferred Stock
The following is a list of common characteristics of preferred stock:
Redeemable: A preferred stock is said to be redeemable or “callable” in that the company that issues the shares reserves the right to redeem them at a pre-determined price and its own discretion.
Participating: This feature enables preferred share holders to participate in the dividends to common shareholders, usually at a pre-determined rate.
Convertible: The convertible option provides preferred shareholders with the option of converting preferred stock to common stock.
Cumulative: Under the cumulative feature, if the company fails to pay its dividend to preferred shareholders, it must make up the dividend before any dividends can be paid to common shareholders.
The Benefits of Preferred Stock Investing for Individuals
The fact that individuals do not enjoy the same tax advantages as corporations should not preclude them from considering investment in preferred stock. Some of the benefits of preferred stock investing for individual investors include:
• Greater price stability and payment priority (of both dividends and liquation proceeds) than common stock holders
• Greater liquidity than many bond holdings
• Relatively low investment per share
The Potential Downside to Investing in Preferred Stock
The “callability” and limited upside potential are the two negative factors most often referenced for preferred stock. Additionally, preferred shareholders do not receive voting rights and, like bond holders, are exposed to interest rate changes.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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