Preferred Shares

What they Are

A preferred share is a special type of stock that regularly pays you a set amoun
t of money out of the company's profits called dividends. They're called preferr
eds because you get preferential claim to the profits ahead of common shareholde
rs.
How they Work
Unlike common shares, preferred shares don't give you the right to share in a co
mpany's fortunes. Your rights end at getting a set amount of dividends and havin
g a prior claim on the company's assets ahead of common shareholders if the firm
goes out of business. Only if the company misses a set number of dividend payme
nts do preferred shareholders have a right to vote in the company's affairs. If
the company earns a profit again, preferred shareholders are usually entitled to
get all the missed dividend payments paid to them before common shareholders ge
t any. Those that don't have this provision are called non-cumulative preferreds
. In many ways, preferred shares are like bonds, except that they don't have a s
et maturity date. They are often issued at a face value, usually $25, $50 or $10
0. The fixed dividend payments - mostly paid every three months - are like a bon
d's interest payments. And they react the same way to changes in interest rates
as bonds do. If interest rates go down, preferred share prices go up, and vice v
ersa. The return on preferred shares is called a yield. You calculate it by work
ing out the dividends per year as a percentage of the price you paid for the sha
res. If you pay $25 for a preferred that pays $1.75 in dividends per year, then
your yield is 7% ($1.75 divided by $25 per share X 100 = 7%). Preferreds also co
me with many features similar to bonds. Convertible preferreds let you exchange
your preferreds for the company's common stock. A redeemable feature is very com
mon and lets the company buy the preferreds back at a set price whenever it want
s to. Retractable preferreds let you turn in the shares to the company at a spec
ific price during specified times. Sinking fund issues are where the company put
s aside money to buy back a number of preferreds each year.
The Risks
Since preferred share prices react to swings in interest rates, you could get le
ss than you paid for your shares if interest rates rise and you have to sell. Th
is is because the yield on your preferreds likely won't be competitive with othe
r investments now that rates have gone up. You will likely have to drop the pric
e so that the fixed dividend gives prospective buyers an attractive return. Ther
e's also the risk that the company will do badly and not have money to pay divid
ends. If this happens, you might also have to sell your shares at a loss. Other
investors won't be interested in a preferred share that isn't paying dividends.
If the company goes bankrupt, you'll likely lose money on your preferreds, but l
ikely less money than if you'd bought the firm's common stock. Preferreds entitl
e you to a set amount of money if the company goes bust. However, you'll only be
paid after bond holders and other creditors have been paid, which might mean th
ere won't be much left.
The Rewards
Yields on many preferred shares are higher than those of other fixed-income inve
stments like bonds. This is because the return is less assured so the higher yie
ld compensates you for taking on the added risk. Since preferred prices respond
in opposite directions to interest rates, you can make a profit by selling them
after interest rates have gone down. The income you get from the preferred share
's dividend is taxed less heavily than interest on bonds, leaving you with a big
ger actual return.