Preferred stocks are bought primarily for dividends
Preferred shareholders have a priority in claims when it comes to liquidation during a bankruptcy. What’s more, preferred stock dividends must be paid before any dividends are paid to common shareholders. On the other hand, preferred shareholders don’t participate in company’s success. Any share rises due to corporate success happen with common stocks. In that sense, preferred stocks are bought to earn income rather than make capital gains. Preferred stocks can fluctuate, but usually around the issue price. A typical issue price is $25. There can be exceptions, though. If preferred shares were issued when yields were much higher than presently, these shares will trade at substantial premium.
Preferred shareholders don’t have voting rights, although there can be exceptions. For example, preferred shareholders may gain voting rights if there were no dividends paid that were due. It is noteworthy to point out that some issues come with cumulative dividends. It means that any unpaid dividends accumulate. For noncumulative shares, if dividends haven't been paid, there's no requirement to pay them later.
Preferred stocks are often issued without maturity dates but can be callable at the option of an issuing company.
Participating and Convertible Preferred Shares
There are also participating preferred stocks. When it comes to fully participating preferred stocks, any extra dividends are split among common and preferred shareholders. For partially participating preferred shares, any extra dividends are set at a specific rate.
Sometimes companies issue convertible preferred shares. These can be later exchanged for common shares at a fixed price. Many investors like them as there’s a potential to benefit from rising common share prices. However, this convertible option isn’t free. The price is paid in the form of lower dividend yields than those on similar shares that aren’t convertible.
Pros and Cons of Issuing Preferred Stock
Overall, few companies issue preferred stocks, and often these shares represent only a small percentage of company’s capitalization. Companies will often issue preferred stocks because investors want them for their price stability, dividends, and preference over common shares when it comes to paying dividends and during liquidations.
An advantage for companies is that it is a way to raise capital without diluting ownership of common shareholders.
On the negative side, companies can defer paying preferred share dividends, meaning investors don’t get paid on time. This can’t be done with bonds without causing trouble. But, for companies that fail on paying dividends to preferred shareholders trouble can come as well. If preferred shares were issued without “cumulative” option that legally allows companies to delay dividends, a call for bankruptcy can occur.
Another disadvantage from investors’ perspective is the inability to influence issuing companies since there are typically no voting rights attached to preferred shares.
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In addition to common stocks, there are also preferred stocks. These two kinds of shares are substantially different.