Preferred shares, also known as preferred stocks, are a distinct type of fixed-income security, combining characteristics of both stocks and bonds. They provide a high dividend yield and consistent dividend payments, and their prices are fairly stable. 

Preferred shares are a valuable instrument for passive income investors, but they are often unjustly overlooked and found confusing by investors. We’ll explain preferred shares, their benefits, and the main differences between them and common stock. We’ll also look at why investing in preferred shares is beneficial for investors and what you should know before investing.

What Are Preferred Shares?

Preferred shares are a fixed-income hybrid security. Like stocks, they are much easily traded on the major stock exchanges, and like bonds, they are issued with a set face value (par value) and pay dividends on a set schedule. They are designed to generate a high dividend yield with a lower investment per share. That makes preferred stocks attractive for investors looking to create stable passive income.

Banks, insurance companies, real estate investment trusts (REITs), utilities, and other financial institutions primarily issue preferred shares. Companies use preferred shares as a debt instrument. In addition to common shares, they can issue series of preferred shares (equity) to raise capital without a negative impact on the balance sheet. It helps the company lower their equity-to-debt ratio.

Preferred shares are a safer way for companies to borrow money and eliminate the risk of a hostile takeover, as preferred shareholders cannot vote. Every quarter the board of directors declares dividend rates for each series of its preferred shares. Unlike with bonds, the company can defer these dividend payments during periods of tight cash flow.

Common Shares vs. Preferred Shares

Growth investing increases capital through actively buying and selling common stocks at profit. Value investing in preferred shares creates a dividend cash flow with a lower risk. In addition to the lack of voting rights, preferred shares are different from common shares in many ways. 

Let’s review the three distinct characteristics:

• Higher yields: Preferred stock dividends are higher than common stock dividends and usually pay fixed dividends. In turn, common stock returns fluctuate and at any point can be eliminated.
• Priority to receive dividends: Preferred stockholders have a priority to receive dividends before common stockholders. For example, if a company doesn’t have enough profit, it cannot suspend dividend payments for the preferred stock without first suspending dividend payments for the common stock. Often, suspending the common stock dividends will save the company enough money, and preferred stock dividends will stay untouched.
• Priority for repayment: If a company becomes insolvent, preferred stockholders have a higher priority for repayment or a greater claim on the company’s assets during liquidation. The common stock shareholders will be paid out last after creditors, bondholders, and preferred shareholders.

Types of Preferred Shares

Various types of preferred shares have unique characteristics, and investors should be aware of the differences before purchasing them.

• Convertible preferred stock: After a specified date, at a set conversion rate, the stockholder has a right to convert these shares to common stock. When the common stock price gets higher than the conversion price, investors can convert the shares to earn a profit. There also may be a provision that allows the company (issuer) to force the stock conversion. A prospectus or other formal offering document will outline the parameters of these options.
• Cumulative preferred shares: If a company’s dividend payments are suspended and then resumed, holders of cumulative preferred shares will still receive all missed payouts. Unpaid dividends will accumulate and won’t expire. They will be paid out as soon as the company has enough profit. Other stocks that do not have this feature are called non-cumulative preferred stocks, and their owners lose the missed dividends.
• Adjustable-rate preferred shares: This type of security has a flexible payout, depending on specific factors predetermined when the shares are issued. Usually tied to a set benchmark, such as Treasury bill yield, the payout fluctuates. The unique floating-rate dividend structure protects the income investor from adverse interest rates and makes the shares more competitive in the market.
• Callable (also known as redeemable) shares: Like with bonds, the stock issuer has a right to redeem or call in the shares at a preset price after a specific date. A company predetermines the terms, such as call price and date, at the time of stock issuance. If the company chooses to redeem (buy back) their shares, they will have to pay a call premium to their shareholders because they will no longer receive dividends. The call premium is a compensation for the reinvestment risk.
• Participating shares: If the common stock dividend is higher than the preferred, the participating shares investor will receive an additional payment. Its total payment will be equivalent to the common stock payout. This type of preferred share is rare, and most preferred shares are non-participating.

Preferred Shares: Benefits For Income Investors

Preferred shares have many advantages for investors. They may provide equity investors with more stable cash flow, behaving more like an investment in bonds than stocks.

Let’s review the main benefits for investors.

• Higher dividend yield: The dividend serves as an incentive to own preferred shares. Companies pay higher dividends to attract investors and compensate them for giving up the right to vote and the lack of price appreciation in shares.
• Lower volatility: Preferred share prices fluctuate less than common stocks and slightly more than bonds. For this reason, investors can use preferred stocks to lower their overall investment portfolio volatility.
• Preferred dividend payout: Preferred shareholders are entitled to receive dividends after bondholders and before common shareholders.
• No fixed maturity date:  Investors can own preferred shares indefinitely, as preferred stocks have a very long maturity date (usually 30 years) — or don’t have a maturity date at all. This is a noticeable advantage over bonds that have a predetermined maturity date.

Preferred Shares: How To Minimize Risks

There are many ways to invest in preferred stocks. You can buy individual preferred stocks, exchange-traded funds (ETFs), and mutual funds. When you invest in individual stocks, you depend on the performance of the selected company, which may come with more risk. It can also be tough to understand the maturity dates and other information on specific preferred stock. 

So, to better manage risk, it is favorable to invest in ETFs or mutual funds that specialize in this equity type.

Preferred shares, like bonds, usually carry a credit rating. Because preferred stocks are lower in the capital structure than bonds, their credit rating is usually lower than bonds. To maximize the safety of your investment, you may choose to stick to investment-grade preferred shares.

Start Investing in Preferred Shares

Preferred shares are a unique tool for investors looking for more secure annual dividends and lower risk of losses, which is especially important when you are retired or close to retirement. 

Preferred shares offer dividends that are generally higher than most stocks, bonds, or other traditional fixed-income investments. They can help reduce your investment portfolio volatility and provide stable income.

To learn which specific preferred stocks with high dividend payouts to buy and hold for stable dividend income, subscribe to Investors Alley’s “Dividend Hunter” newsletter.