CNBC Explains

Preferred Stock: CNBC Explains

Preferred stocks are a special class of investments with several unique features. Those features often make them confusing to investors.

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So what exactly are preferred stocks? How are they different from common stocks and why would someone want to own them? CNBC explains.

What are preferred stocks?

Preferred stocks are a hybrid of sorts, as they have features of both stocks and bonds. Like common stocks, they represent ownership in a company. Like bonds, companies must pay on a regular basis a set amount of interest to preferred stock shareholders.

Another similarity to bonds is that the dividends to investors from preferred stocks are taxed at ordinary income tax rate, rather than the higher investment rate.

Preferred stocks have been around for a long time.The earliest issue was reportedly in 1836 in Maryland. They gained greater popularity in the 1990s. They are issued by companies in other countries including Canada, Germany, the U.K, Brazil and France.

Why do companies issue preferred stocks?

Companies issue prefer stock for any number of reasons, but usually because investors want them. (See the advantages and disadvantages listed below)

It's interesting to note that preferred stock usually occupy a small percentage of the overall mix of a company's funding when compared to common stock or debt. Preferred stock typically accounts for less than 10 percent of a company's overall sources of funding.

One reason for the low amount is that firms would rather issue bonds than preferred stocks because the interest expense on the bonds serves to reduce a company's tax liability. In other words, bonds are a tax write-off, while preferred stock is not.

But one selling point for preferred stocks is that they can be redeemed by the issuing firm before they are scheduled to mature—like a bond— and this gives the company the ability to use preferred shares of stock for a specific funding purpose.

One industry that does seem to like issuing preferred stocks is the utility industry. That's because preferred stock dividends are treated like an expense for rate-making purposes. Simply put, utilities can pass on the cost of the dividend payment in the rates they charge their customers.

What are the advantages of owning preferred stocks?

Because preferred stock normally has higher and more regular dividends, it is less volatile than common stock and carries less risk. A preferred stock with a guaranteed dividend is often considered a fixed-income investment similar to a bond.

Another advantage to owning preferred stock is when a company stops paying a preferred dividend. The company must repay all the money it would have paid to preferred shareholders before it can pay any dividends to common shareholders.

On the flip side, if a company grows, the stock value can appreciate and so can dividend payouts. For investors, this fixed-income characteristic makes preferred stock a good choice for long-term retirement investments, like an IRA.

Another important characteristic of preferred shares is that sometimes, but not always, they give their owners the right to convert that preferred stock into common stock at a prearranged price. This is attractive to preferred stock holders because they are entitled to the steady stream of dividends, plus they can enjoy appreciation in value if the company's common stock rises.

What are the downsides of preferred stocks?

Preferred stocks carry less risk than common stock, but they have more risk than bonds and may not offer a better income from dividends than the interest on bonds. Because of the added risk, investors who own preferred stocks could see larger short-term losses than with bonds.

Just as with common stock, preferred stockholders are behind bond holders in line for a company's assets if it runs into a financial problem. If a company fails, money is repaid to bond holders first. This adds default risk to preferred stock.

Another downside is that preferred shareholders are usually excluded from voting on matters such as board of director elections.

One other point to make—there is no preferred stock rating system similar to what's available with bond ratings.