What Are Preferred Securities?
Preferred shareholders have a class of ownership in a company and take priority when it comes to dividends. Since preferred shares are higher in structure, investors are offered greater protection in the event that the company goes bankrupt. They are traditionally advertised to income-seeking investors, who are drawn to their dividend payment returns.
Also referred to as hybrid investments, preferred stocks possess characteristics of both debt and equity. Similar to traditional debt, preferred stocks carry priority over common stock for dividend payments and bankruptcy proceedings. Additionally, preferred shares offer a fixed dividend payment similar to bonds.
On the other hand, preferred stock is similar to equity in that their value can fluctuate, especially when the issuing firm’s value is low. Further, preferred shares are given ratings like bonds, but are almost always lower due to a difference in interest payment guarantees. Since they are complex investments, it’s important that your portfolio be carefully curated to avoid any risk.
Types of Preferred Stock
Four main types of preferred stock can be issued by a company. Licensed brokers should inform their investors about each type in detail as they relate to personal portfolios. They include:
- Participating preferred stock: Those with this type of preferred stock can receive higher-than-average dividends if the company experiences a higher-than-average profit.
- Convertible shares: Investors with convertible preferred securities can convert their investments into a specified number of common shares.
- Cumulative preferred stock: If a company skips dividend payments during a less profitable period, investors with cumulative preferred stock reserve the right to accumulate the skipped payments and take priority when they resume.
- Non-cumulative preferred stock: The opposite of cumulative preferred stock, those with non-cumulative shares won’t receive skipped dividend payments.
Preferred Stock Risk
Just as it is a broker’s responsibility to inform you of preferred stock benefits, so too must they warn you of the risks. Although marketed as a stock with fixed income similar to that of bonds, in times of market crisis, preferred shares act more like common stock. As a result, investors with preferred stock miss the upward price increase that common stocks present, but are exposed to the downward declines.
Additionally, many preferred stocks are callable, meaning that the issuer can repurchase the shares at par value and cease dividend payments. Further, if interest rates fall in a volatile market, companies have an incentive to call the security, thus giving preferred shares an inherent interest rate risk.
The threat of industry sector concentration is also present with preferred stocks. Since regulated companies, such as those in the financial or insurance sectors, can carry preferred shares as equity on their balance sheet, many choose to issue preferred shares rather than traditional debt. Moreover, they issue preferred stocks in bulk to raise large amounts of capital. As these institutions are highly susceptible to the changing market conditions, it’s crucial that your portfolio is constructed in such a way that the risk is mitigated.