Preferred stock: priority without a vote

Equity built to behave like income

Preferred stock is equity, but it is designed for investors who want a steady payment rather than control. It carries a stated dividend, usually expressed as a percentage of a $100 par value — a 6% preferred on $100 par has a stated annual dividend of $6. Dividends depend on declaration and the terms of the shares; the stated rate is not a payment guarantee. Preferred dividends have priority over common dividends. In a liquidation, preferred ranks ahead of common but behind every creditor.

The price of the priority is silence. Preferred normally carries no vote. And because the payment is fixed, the market prices preferred much as it prices a bond: when interest rates rise, a fixed $6 dividend becomes less attractive and can put downward pressure on the share price. Other risks also affect the price. The issuer likes preferred because a skipped dividend is not a default, whereas a missed bond coupon can result in default.

Four optional features change the deal. Cumulative: any skipped dividend accumulates as arrears, and every dollar of arrears must be paid before common receives anything. Participating: in a very good year the preferred may receive an extra dividend above its stated rate. Convertible: the holder may exchange each share for a set number of common shares, so it can give the holder exposure to a rise in the common share price. Conversion does not guarantee a gain.

Callable: the issuer may redeem the shares at a set price after a set date. This is the one feature that favors the issuer — falling rates may give it an incentive to redeem and refinance more cheaply, subject to the share terms. A call is not automatic. Straight, non-cumulative preferred is the base case: a skipped dividend is simply lost.

Conversion has two sides worth knowing. In most convertibles the holder decides when to convert, though some terms give that right to the company. Conversion creates new common shares, which dilutes existing common holders, and the converting holder gives up preferred priority for dividends and in liquidation.

Exam terms

Stated dividend

The fixed annual payment, quoted as a percentage of par; paid only if declared.

Cumulative preferred

Skipped dividends accumulate and must be paid in full before any common dividend.

Participating preferred

May receive a dividend above the stated rate when the company does well.

Convertible preferred

Usually exchanged at the holder’s choice (some terms let the company decide) for a fixed number of common shares.

Callable preferred

May be redeemed by the issuer at a set price after a set date.

Dividends in arrears

Skipped dividends that must be paid before common dividends; payment is not guaranteed.

Worked example

Yarrow Textiles has 7% cumulative preferred stock with a $100 par value. It paid no preferred dividend in year one or year two. In year three the board wants to pay a common dividend.

1. The stated dividend is 7% of $100, so $7 per share each year.
2. Two skipped years create arrears of $7 + $7 = $14 per share.
3. Year three’s own $7 must also be paid, so preferred holders receive $21 per share before common gets anything.
4. If the preferred were non-cumulative, the two skipped years would be lost and only the current $7 would stand in the way of a common dividend.
5. If the preferred were also participating, holders might receive something above $7 in year three — but that extra depends on the participation terms and a declared dividend, not on any arrears.

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Related practice

• Preferred stock featuresPractice this