Preferred Stocks as an Investment Option

We come across the terms - Preferred Stock, or Preference Shares, interchangeably which, by definition, is a kind of corporate ownership that combines features of both bonds and common stock/ordinary shares. A preferred stock (we will carry forward the discussion, taking this term as the representative to understand the topic), is a class of stock that typically has a higher priority and a greater claim on the distribution of the company’s assets and earnings as compared to ordinary stock. Preferred stock has distinct characteristics that make it an attractive investment option. However, understanding the advantages vis-à-vis its disadvantages can help investors make better informed decisions and diversify their investment portfolios.

Types of Preferred Stock

1. Cumulative: guarantees that if a company does not pay dividends over a specific period, the unpaid dividends will accumulate and must be paid before any dividends are granted to common shareholders.
2. Non-Cumulative: does not allow unpaid dividends to accumulate. If the company fails to pay dividends during a given period, non-cumulative preferred shareholders do not have a claim to unpaid dividends in the future.
3. Convertible: allows shareholders to exchange their preferred stocks for a set number of common shares. This feature allows preferred shareholders to profit from capital growth in the company’s common stock.
4. Participating: entitled to additional dividends over and above the predetermined dividend rate.
5. Callable: right to repurchase the shares at a specific price after a predetermined time. This gives the company the flexibility to buy back preferred shares from shareholders, typically when interest rates have dropped, or the company needs to restructure its capital.
6. Adjustable Rate: also known as floating-rate preferred stock, has a dividend rate that changes based on a predetermined benchmark or index. This ensures that the dividend payout reflects the current state of the market, including any changes in interest rates.

Advantages

• Fixed Income: frequently pay a fixed dividend, providing investors with a steady income stream
• Tax Benefits: Dividends may be tax deductible, which helps lower the overall cost of ownership
• Priority Payouts: In case of bankruptcy, the investors are assured a priority in receiving funds
• Call Feature: as it grants the issuing corporation the ability to repurchase shares of preferred stock at a predetermined price, if the market price of the stock surpasses the call price, there is an opportunity to investors, potentially resulting in higher returns
• Conversion Feature: a conversion provision enables shareholders to convert their preferred shares into common shares. Investors who anticipate better performance from the common shares in the future may find this feature advantageous, as it allows them to participate in potential gains

Disadvantages

• Growth Potential: often does not increase in value as much as common stock
• Risk of Default: it is common as it functions as a debt instrument. If the issuing firm fails to fulfil its obligations, preferred investors may not receive their expected dividends.
• Limited Voting Rights: investors often lack voting rights; hence they do not influence how the corporation is governed