This lesson will define the hybrid investment security called preferred stock. The various types of preferred stocks will be explained and advantages of each will be explored.

Preferred Stocks

Preferred stock is an investment security which, depending on the issuing company, can represent ownership in a corporation along with being a debt instrument of the company. The fact that preferred stock can be represented on both sides of the company’s balance sheet – representing ownership as well as a liability – indicates that preferred stock can be construed as a hybrid investment security.

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When purchasing preferred stock, think as though you are loaning the company money. When loaning money to a friend, you expect to be paid back with interest. Preferred stock works in a very similar fashion. A preferred stock may be issued at $25 per share and may trade on the stock market. Preferred stock dividends typically must be paid prior to a corporation issuing dividends to common stock holders.

There are five main types of preferred stock:

  1. Cumulative
  2. Participating
  3. Convertible
  4. Callable
  5. Adjustable-rate

Definitions ; Advantages

Cumulative preferred stock is a type of preferred stock that pays a fixed dividend at regular intervals, typically quarterly. If a dividend is not paid, the sum of the unpaid dividends accumulates and must be paid prior to common stockholders being issued a dividend. Preferred stock may also be designated as non-cumulative.

Participating preferred stock is a type of preferred stock in which preferred stock holders may be issued a special dividend if certain financial goals are achieved by the company. One financial goal may be that the share price of the common stock increases above a predetermined level. Participating preferred stock is mainly issued by newer companies that are in need of a cash infusion. Preferred stock may also be designated as non-participating.

Convertible preferred stock is a type of preferred stock in which preferred stock holders may convert their shares of convertible preferred stock to shares of common stock of the same company. Having this option allows the preferred stock holders to potentially benefit from a rise in share price in the common stock, as typically the preferred stock allows them to convert to common stock at any point. It is important to note, however, that typically the conversion is 1-sided, in that you cannot convert back to preferred stock. Preferred stock may also be designed as non-convertible.

Callable preferred stock is a type of preferred stock which is callable at a given date in the future at the issuer’s discretion at the redemption price. The redemption price may be the original issue price or slightly higher than the original issue price. This type of preferred stock is more advantageous to the issuer, as the preferred stock holder is not given the option to refuse the call; rather, the shares of the preferred stock that has been called is exchanged for the liquidation preference amount. Preferred stock may also be designated as non-callable.

Adjustable-rate preferred stock is a type of preferred stock in which dividends vary with a specified benchmark, typically the T-bill rate. Because the dividends vary with interest rates in adjustable-rate preferred stock, the share price of these securities may be less variable that the share price of non-adjustable-rate preferred stock. How often the dividend rate in adjustable-rate preferred stock changes is defined in the prospectus and may have a minimum and a maximum.

Lesson Summary

Preferred stock is an investment security which, depending on the issuing company, can represent ownership in a corporation along with being a debt instrument of the company. The benefit of owning preferred stock over common stock is that the dividend of preferred stock is typically fixed and must be paid prior to common stock holders receiving dividends.

There are generally five types of preferred stock: cumulative, participating, convertible, callable, and adjustable-rate. A cumulative preferred stock pays a fixed dividend at regular intervals, typically quarterly. With a participating preferred stock, preferred stock holders may be issued a special dividend if certain financial goals are achieved by the company. Convertible preferred stock is a type of preferred stock in which preferred stock holders may convert their shares of convertible preferred stock to shares of common stock of the same company. A callable preferred stock is callable at a given date in the future at the issuer’s discretion at the redemption price. With an adjustable-rate preferred stock, dividends vary with a specified benchmark, typically the T-bill rate.

Each of these types of preferred stocks has various advantages, and in some cases the advantage may be to the issuing company’s benefit rather than the preferred stock owners. It is important to read the prospectus to ensure you are making an informed decision.