Income‑focused investors often find it pays to look beyond the most well‑traveled hunting grounds in their search for reliable yield.
One asset class that is often overlooked or misunderstood, but that can provide a rich terrain, may be preferred stocks. With a structure that combines characteristics of both stocks and bonds—such as fixed dividend terms and payment priority—they can provide a distinctive source of income within a diversified portfolio.
What is preferred stock?
Preferred stock is a stake in a company, traded on exchanges like common stock. And while “stock” is in the name of both securities, preferred stocks have more similarities to bonds than to common stocks. Common shares are plentiful and trade on exchanges throughout the trading day. Preferred shares also trade on exchanges but are in much shorter supply.
What is "preferred" about preferred stocks?
Preferred shares get their name from the fact that they give their owners a “priority claim” whenever a company pays dividends or distributes assets to shareholders. In other words, holders of preferreds get paid first.
The exact terms of the “preference” that preferred shareholders’ get may vary from company to company. In some cases, the preference simply means that cash available for distributions during the year must be paid to preferred shareholders before common dividends are paid. In other cases, the preference means that any missed payments to preferred shareholders must be made up before common shareholders are allowed to receive anything.
When might it make sense to invest in preferred stocks?
Like bonds, preferreds can help investors to preserve capital and generate income. For those approaching the end of one phase of their working lives, the reliable income payments that preferreds deliver can help smooth the transition to living on a smaller salary while also offering the potential for capital appreciation. Bonds and dividend-paying stocks can also offer these things, but preferreds may offer some of the most appealing characteristics of both stocks and bonds in one place.
Preferred stocks vs. common stocks vs. bonds
Common stocks, bonds, and preferred stocks differ in 4 ways: Priority, price, dividends, and voting rights.
Priority. Preferred shareholders always receive dividends and asset payouts before holders of common shares. In case of bankruptcy, the claims of preferred stockholders on the company’s remaining assets are paid before those of common stockholders but after bondholders.
Price. Like a bond, a preferred share has a face or "par" value—usually $1,000 par preferred stocks geared toward institutional investors, and $25 par preferred stocks geared towards retail investors—which is used in calculating the value of its dividend. When a preferred stock trades in the market, it may be at a price above or below par. In contrast, a common stock’s value depends entirely on its market price, which tends to make common shares more volatile than preferred shares.
Preferred shares generally rise in market price when interest rates fall, and fall in market price when interest rates rise—just as traditional bonds do.
Dividends. While many common stocks pay dividends, those payments are entirely discretionary and can be raised, reduced, or suspended at any time. Preferred stocks, by contrast, typically pay a fixed dividend rate tied to their par value, and they come with stronger protections than common stock dividends. The rate of dividends is often often specified in the name of the preferred stock: for example, “Arlington Asset 7.00% Series B Cumulative Preferred Stock.”
Voting rights. In exchange for lower volatility and higher income, preferred shareholders give up voting rights. Common stockholders can vote on matters of corporate governance, but those who hold preferred stocks typically can’t.
Things to consider about preferred stocks
Preferred stocks offer many attractive features, but they are not a single solution to all of your investment needs. They do not typically provide as much growth potential as growth stocks, which can raise the risk that you fall short of your savings goals if you allocate too much to them. Their lower historical returns compared to common stocks also raise the possibility that a portfolio with too big an allocation to preferreds may not grow enough to keep up with persistent inflation over the long term. As with stocks, dividends paid on preferreds may not be guaranteed. And like bonds, some preferreds can be redeemed early, or "called," by their issuers.
How to buy preferred stock
If you think preferred stock could help you achieve your income investing goals, you'll first need to open an investment account. Once you've opened an account, buying preferred stocks is just a screening tool away. As with sorting through your options on any security, some of the features you’ll want to consider include:
- Payment features—such as payment frequency (e.g., quarterly) and whether dividends are fixed, floating, or cumulative
- Dividend rate and yield—the stated dividend relative to par value, and the yield based on the current trading price
- Call and redemption features—Most preferreds are perpetual and do not have a maturity date, but many include call provisions that allow the issuer to redeem them after a specified call date.
- Convertibility—whether the preferred can be converted into common shares
- Credit rating—which reflects the issuer’s financial strength and affects the stability of the dividend.
Tools that can help you research and buy preferred stocks
Preferred securities are more complex than common stock or bonds. And, while they offer higher yields, they also carry additional risks that should be considered before investing.
You can use Fidelity's Preferred Security Screener to help find financially strong companies with preferred securities. With a variety of filtering criteria, you can screen for payment, maturity, call and convertibility features, and more.