Preferred stock is a type of investment that provides both income and the possibility of growth.
Most investors in companies buy common stock. Bondholders also are invested in a company’s future. A bond must be paid back with interest. That happens only if the company stays in business and prospers.
A third type of investment, preferred stock, provides an income stream like a bond and the growth potential of a common stock, plus additional advantages.
For instance, preferred stock is given priority when dividends are paid. If dividends are suspended, payments accumulate and get paid out first, before common stock dividends resume.
If a company goes under, preferred stock owners are given a higher claim on the company’s assets. They are behind bondholders but ahead of common stock investors.
Many large U.S. corporations are mature businesses. They generate steady earnings cash that is not easy to reinvest. Their markets are crowded or they face heavy regulation. Two examples are telecoms and utility companies.
Investors want growth or income from an investment. Small-cap firms can be counted on for growth. Large-cap companies, while more stable, tend to grow more slowly.
If a company is large and profitable, its bonds can be oversubscribed. High demand means the bonds pay a low rate of interest. Preferred stock thus allows the investor to enjoy a more attractive dividend payout while receiving some of the protections a bond investor would require.
Preferred stock has two important features to understand: convertibility and call provisions.
Convertibility means that a preferred stock holder can convert preferred stock shares into common stock. This can be good if the common stock price rises significantly over the years, since convertible shares are more likely to track along with the common stock price.
A call provision means that the company has the right to call back the stock after a given date. This could happen if interest rates fall and the company wants to reduce its cost of capital through refinancing.