Preferred Stock Basics

Ask three average investors to define "preferred stock," and you'll probably get answers like this:

  • "It's sort of a bond and sort of a stock, only less so."
  • "I think it's like a stock with no voting rights. But you get more dividends, and you get paid before common stockholders if the company liquidates. Is that it?"
  • "I don't know, man, but I prefer stocks that make me a lot of money, yuk yuk!"

As it turns out, all of those answers have some truth to them. Preferred stocks do combine elements of common stock and bonds, they do lack voting rights but have a dividend and precedence over common stocks, and most long-term individual investors should be buying good common stocks instead. But preferred stocks (or "preferreds" for short) are useful investments in some situations. It's worth knowing what they are, how to buy them, and when you should consider owning them.

The basics
Preferreds, which are generally sold with institutional investors in mind, seem to come in a bewildering variety of configurations. But for the most part, the features are actually pretty straightforward. Like common stock, preferred stock is usually traded on a stock exchange and represents an ownership interest in the company (unlike a bond, which is a securitized debt). But like bonds, preferred stocks usually have a fixed payment stream -- which is often tax-advantaged -- and no voting rights. Many preferreds are issued at a price of $25 or $50 per share, and while prices do trade up and down, they are generally less volatile than common stock prices.

The usual risks of preferreds are a lot like the risks around corporate bonds. Rising interest rates can make the payment stream less attractive. If the company goes out of business, it'll often take your money with it. Also, with preferred shares, liquidity can sometimes be a problem -- meaning that if you have to sell in a pinch, you might be stuck, or at least compelled to take less money than you think your stock is worth.

A preferred stock may also fall into some or all of the following categories:

  • Convertible. A preferred that is convertible can be converted into common stock at a set price after a set date, usually at the shareholder's option. As that date approaches, the preferred will trade more and more like the common. (A preferred that isn't convertible is called a straight preferred stock.)
  • Callable. A callable preferred stock can be "called" -- repurchased by the company -- at a fixed price, after a certain period (usually five years), at the company's option. Most preferreds are callable, and unfortunately for investors, they tend to get called when interest rates are falling -- making other sources of financing more attractive to the company.
  • Cumulative. Most preferreds are cumulative, meaning that if the company ever misses a dividend payment, it will accrue and be owed to stockholders later. In general, preferred shareholders are above common stockholders in the pecking order of dividends. Before a common stock dividend can be paid, all payments to preferred stockholders must be up to date. Preferreds that aren't cumulative -- there aren't many, but they exist -- usually have a higher yield to compensate for the added risk.

Why would I want one?
Does a 6% yield taxable at 15% (sometimes 5%) sound appealing? For a retiree looking for income outside of a tax-advantaged retirement account, the right preferred stock can be a great option. For more sophisticated investors, convertibles selling at a discount can sometimes offer great opportunities to invest in a company -- allowing an investor to receive an income stream while waiting for the common stock to rise before choosing to convert.

For example, if you're bullish on Ford (NYSE: F  ) , you can invest in Ford's convertible preferreds (NYSE: F-PS  ) , which trade at a discount from their $50 call price, are convertible into 2.8249 shares of common, and pay 6.50%. The convertible feature is still "underwater" -- the price that would be realized from a conversion is higher than the current common stock price. But the tax-advantaged 6.50% dividend is a nice incentive to stick around while waiting for the company's recovery plan to take hold, especially since the company isn't currently paying dividends on the common stock. Other companies that offer preferred shares include General Motors (NYSE: GM  ) , Chesapeake Energy (NYSE: CHK  ) , and Freeport McMoRan (NYSE: FCX  ) .

Want to learn more? Check out the Fool's preferred stock primer for a more elaborate walk through the basics. You'll also find a terrific how-to article on preferred stock investing among the back issues of the Fool's Rule Your Retirement newsletter service. A free trial gives you full access to all of the great advice and ideas offered up by Fool retirement guru Robert Brokamp and his team every month, along with three years of archives. Grab your free pass now.

Fool contributor John Rosevear prefers common stocks, for the most part, and does not own any of the securities mentioned here. The Fool's disclosure policy prefers convertibles, particularly fast red ones with racing stripes and dual sidepipes. Vrooom!


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