Just based on its name, preferred stock sounds like the sort of investment reserved for those who always fly first class, stay in the top hotels, and have VIP passes to the hottest nightclubs and concerts. Meanwhile, all of us coach flyers who get stuck waiting in long lines have to settle for plain old common shares.

It's not surprising, therefore, that investing interest in preferred stock has risen recently. But despite having some benefits when it comes to paying dividends, preferred stock isn't always a preferable investment in comparison to the common stocks with which most of us are much more familiar.

How preferred stock works
To understand the concept of preferred stock, you have to look at the capital structure of a typical corporation. In the hierarchy of claims against company assets, those who lend money to a corporation, whether through direct loans by banks and other financial institutions or in the form of bonds that investors can buy through public offerings, have top priority when it comes to getting paid back.

In contrast, those who contribute capital in exchange for an equity interest -- shares of stock -- stand behind all of the company's creditors. If a company has to liquidate, then unless lenders are paid in full, shareholders aren't entitled to a dime.

With debt, different lenders typically have dissimilar rankings, depending on the terms of each financing. Secured debtors and senior debtholders have priority over junior debtholders.

Preferred stock imposes a similar rank order on the equity side. If there's any money left for shareholders, those who own preferred stock have priority over common shareholders. Only if preferred shareholders get the full amount of their preference do common shareholders divide any remaining assets.

Why investors like it
In addition to the liquidation preference, traditional preferred stock typically pays a higher dividend yield than common shares. Here are some examples:


Yield on Common Stock

Yield on Preferred Stock

Goldman Sachs (NYSE:GS)



International Paper (NYSE:IP)



JPMorgan Chase (NYSE:JPM)



Kimco Realty (NYSE:KIM)






RenaissanceRe (NYSE:RNR)



US Bancorp (NYSE:USB)



Sources: Yahoo! Finance, SEC filings. As of June 25.

As illustrated above, you can earn a lot more income from many preferred share issues than you can from investing in common shares. As interest rates on bank CDs and other fixed-income securities have remained relatively low, and as many companies have cut back on dividend payments, preferred shares have started to look increasingly attractive.

That's one reason why ETFs that focus on preferred stock have started to take root. While many preferred issues are thinly traded, ETFs offer an easy way to build a diversified portfolio of preferred stocks.

The price you pay
Judging from the bigger stream of income, preferred stock looks like a smart move. But there's a catch. Typically, the issuing company retains the right to redeem preferred shares for a fixed amount.

What that means in practical terms is that while you can still potentially lose your entire investment if the company fails, your upside is severely limited if the company does well. So, with a successful company, common shareholders may see their stock multiply in value, but traditional non-convertible preferred shareholders typically miss out on those big gains.

Should you own preferred stock?
For those willing to take some risk for enhanced returns, preferred stock can play a useful role in helping investors generate income. But even though it's technically an equity investment, its behavior more closely resembles that of bonds and other fixed-income investments.

So, don't let the word "preferred" trick you into thinking preferred shares are always a better bet. If you're looking for big returns from your stocks, sticking with common is the right way to go.

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Fool contributor Dan Caplinger likes the idea of convertible preferred stock, but that's a story for a different day. He doesn't own shares of the companies mentioned. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy lets you make smarter decisions.