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Why Is Preferred Stock Considered a Hybrid Security?

By Motley Fool Staff – Updated Nov 1, 2016 at 2:02PM

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Preferred shares combine elements of both bonds and common stocks.

When most investors think about stock, they tend to focus on what are known as common shares of a company. However, some companies issue a second type of ownership interest known as preferred stock. As the name suggests, preferred stock has some preferences over common stock, but it also comes with trade-offs that make it behave more like a hybrid between common stock and a bond.

What preferred stock is
Preferred stock has two main characteristics that distinguish it from common stock. First, if a company liquidates, any money that's left over for shareholders goes first to holders of preferred stock up to a set amount, and only if there's any remaining after that do common shareholders get anything. Second, preferred shareholders have preferential treatment with dividends, and if the issuing company doesn't pay the full amount of dividends set forth in the prospectus, then it can't pay common shareholders any dividend.

Preferred stock has a par value that the company assigns when issuing it. That value establishes the base on which dividend payments are calculated and often fixes the price at which the company has the right to redeem shares under set conditions. In some cases, preferred stock is created with a fixed final redemption date, while in others, preferred stock can be perpetual without any pre-set date on which the company will redeem the shares.

Preferred stock: more like a bond or a stock?
When you think about it, the characteristics of a preferred stock closely resemble those of a bond or other fixed-income security. The par value is equivalent to the face value of a bond, and the dividend rate specified in the prospectus matches up to the coupon rate of the bond.

However, there's a key aspect that makes preferred stock unlike a bond: the company has the right not to pay a dividend on preferred stock. With a bond, failure to make interest payments would trigger a default that would immediately give bondholders rights against the issuing company. Preferred shareholders only have the right to receive any dividends before common shareholders do, and they have no resource if the company chooses not to pay dividends on any of its preferred or common stock.

Finally, certain types of preferred stock have even more of a hybrid element. Convertible preferred stock gives the owner the right to trade shares of preferred stock for a certain number of common shares. As a result, convertible preferred stock often trades in line with common shares as the common share price goes up, but its price movements will look more like how bond prices move if the common stock falls in value.

Preferred stock shares elements of bonds and common stocks, and as such, many consider it to be a hybrid security. Depending on what type of exposure you want, preferred stock can be a good solution for many investors.

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