Preferred Shares in Plain English

If you are on the hunt for investment income you might consider buying preferred shares.  Many investors are drawn to these puppies because they provide more income than bonds and more stability than stocks.  A no-brainer….right?  Not so fast.   First let’s consider how they work.  Then we’ll look at how smart an investment they are.

How Preferred Shares Work

Preferred shares (also called preferred stocks) are pretty straight forward. You give a company your money. They pay you a fixed dividend (as long as they have the cash to do so).  They give you preferential treatment (compared to common stock shareholders) with respect to dividends and repayment in case of liquidation or bankruptcy. You’ll probably get higher dividends than common shareholders, and you’ll get your dividends before the common shareholders. Meaning, until you get your full dividend, the common shareholders won’t get zilch. That’s why they call these investments preferred shares, and it can be an important part of dividend investing.

How are preferred shares like bonds?

They pay preferred shareholders a set amount – just like bonds. But they pay each quarter rather than every six months like bonds do. The payment is called a dividend because it isn’t an obligation of the company. If you own preferreds and the company doesn’t pay, you can’t sue them for breach of contract like a bond holder can. Bond interest payments are contractual obligations. If a company misses a bond payment, they are in default. If a company misses a preferred dividend payment, the company is not in default. (Read “How Do Bonds Work?”)

How are they like equities?

They are like equities in that preferred shareholders aren’t promised anything from the company, as I mentioned. If the company has the money, it will pay the interest. If it doesn’t have the cash, it won’t make the preferred stock payment. Some preferred shares are “cumulative” – that means the company has to pay the preferreds all the dividends they missed in the past (if any) before the common shareholders get anything. In almost all cases, preferred dividends are a fixed amount and the amount doesn’t change.

What’s the pecking order?

Bond holders have to get paid before preferred shareholders, and preferred shareholders have to get their dividends before any dividends are paid to the common stock shareholders. That is known as the priority, and that priority follows through in case of liquidation. In such a case, bond holders would get paid, and then preferred shareholders. After these two groups of investors get their money, anything left goes to the common stock shareholders.

What are the pros and cons of owning preferred shares?

The answer depends on what you are looking for and what kind of preferred shares you buy. Some preferred shares are convertible into common stock. They are called convertible preferred shares. That’s a nice feature because it’s a way for investors to get their cake and eat it too. If the common stock price doesn’t go up, they still collect their quarterly dividends at least. If the share price goes sky high, they can convert into common shares and take advantage of the growth. Sweet. But keep in mind that in most cases, the common stock price has to go up significantly before these preferred shares convert. As a result, preferred shareholders don’t get all of the price appreciation that common shareholders do.

Preferred shares don’t have voting rights (neither do bonds). Only common shareholders vote.

Bonds have a due date. That means the company will have to repay the debt at some fixed time. Preferred shares don’t. That means the company never has to redeem the shares. That adds risk to the preferreds. The company never has to pay you back. In fact, they never have to give you anything.  If you no longer want to hold the preferred shares you can sell them for the going price.

In summary, the preferred shareholder doesn’t benefit by future earnings. They also don’t enjoy benefits if the common shares rise in value. That usually won’t impact preferred shareholders. Also, bonds have more security as they have to get paid while the preferred shareholders don’t.

So why would anyone buy a preferred share? Because the dividends they pay are usually much higher than the bond interest payments. This is because the risk of owning these shares is higher. That is the main reason people buy preferred shares in the first place – for the dividend.

So if you are looking for investment income, preferred shares might be a good alternative.  But as I’ve written about before, I believe there are far better ways to provide more investment income over the long-haul.

Have you purchased preferred shares? Why or why not?