Preferred stocks pay dividends like common stock. The difference is that preferred stocks pay agreed-upon dividends at regular intervals. This quality is similar to that of bonds. Common stocks may pay dividends, depending on profitability. Preferred stocks’ dividends are often higher than common stocks’ dividends. Dividends can be adjustable and vary with LIBOR, or they can be fixed amounts that never vary. Preferred stocks are also like bonds in that you’ll get your initial investments back if you hold them until maturity. That’s 30 years to 40 years in most cases. Common stocks’ values can fall to zero. If that happens, you will get nothing. Companies that issue preferred stocks can recall them before maturity by paying the issue price. Like bonds and unlike stocks, preferred stocks do not confer any voting rights.
When You Should Buy Preferred Stocks
You should consider preferred stocks when you need a steady stream of income, particularly when interest rates are low, because preferred stock dividends pay a higher income stream than bonds. Although lower, the income is more stable than that of common stock dividends. Higher interest rates make preferred stocks lose value. That’s true with bonds as well. The fixed income stream becomes less valuable as interest rates push up the returns on other investments. Preferred stocks could also lose value when stock prices rise, because companies may call them in. They buy the preferred stocks back from you before the prices get any higher.
Preferred Stocks Versus Common Stocks
This table illustrates the differences among preferred stocks, common stocks, and bonds. Cumulative preferred stocks allow companies to suspend dividend payments when times are bad, but they must pay all of the missed dividend payments when times are good again. They must do that before they can make any dividend payments to common stockholders. Preferred stocks without that advantage are called “non-cumulative stocks. " Redeemable preferred stocks give the company the right to redeem the stock at any time after a certain date. The option describes the price the company will pay for the stock. The redeemable date is often not for a few years. These stocks pay a higher dividend to compensate for the added redemption risk. Why? The company could call for redemption if interest rates drop. They would issue new preferreds at the lower rate and pay a smaller dividend instead. That means less profit for the investor.
Why Companies Issue Them
Companies use preferred stocks to raise capital for growth. The corporation’s ability to suspend the dividends is its biggest advantage over bonds. It just requires a vote of the board. They run no risk of being sued for default. If the company doesn’t pay the interest on its bonds, it defaults. Companies also use preferred stocks to transfer corporate ownership to another company. For one thing, companies get a tax write-off on the dividend income of preferred stocks. For example, if a company owns 20% or more of another distributing company’s stock, they don’t have to pay taxes on the first 65% of income received from dividends. Individual investors don’t get the same tax advantage. Second, companies can sell preferred stocks quicker than common stocks. It’s because the owners know they will be paid back before the owners of common stocks will. This advantage was why the U.S. Treasury bought shares of preferred stocks in the banks as part of the Troubled Asset Relief Program (TARP). It capitalized the banks so they wouldn’t go bankrupt. At the same time, the Treasury wanted to protect the government. Taxpayers would get paid back before the common shareholders if the banks were to default at all. Preferred stocks are often issued as a last resort. Companies sell them after they’ve gotten all they can from issuing common stocks and bonds. Preferred stocks are more expensive than bonds. The dividends paid by preferred stocks come from the company’s after-tax profits. These expenses are not deductible. The interest paid on bonds is tax-deductible and is cheaper for the company.
