What Is a Preferred Stock? And How Does It Work?

Do you know what you get when you cross a common stock with a bond? (Nope, this is not the start of some lame dad joke). You get something called a preferred stock.

The preferred stock is the Frankenstein monster of the investment world. They take bits and pieces from both common stocks and bonds and smash them together to create an entirely new thing.

Preferred stocks have been around for a while, but more and more companies are starting to offer them as an alternative to boring old bonds for raising cash and attracting investors looking for a steady stream of income.

But what exactly is a preferred stock? And are they worthy of a place inside your investment portfolio? Let’s find out!

What Is a Preferred Stock?

A preferred stock is a type of “hybrid” investment that acts like a mix between a common stock and a bond. Like common stocks, a preferred stock gives you a piece of ownership of a company. And like bonds, you get a steady stream of income in the form of dividend payments (also known as preferred dividends).

In terms of risk, preferred stocks are riskier than bonds, but a little less risky than common stocks. As the name suggests, preferred stockholders have some privileges that common stockholders don’t. But at the same time, they don’t have the same guarantees that bondholders do. 

In a world where bond returns are barely enough to keep pace with inflation, some investors are looking for an alternative that will help them receive a reliable income stream. That’s why preferred stocks are getting a closer look by some investors.

How Preferred Stocks Work: Preferred Stock vs. Common Stock vs. Bonds

Preferred stocks can be bought and sold on exchanges (like their close cousin the common stock) at their par value, which is basically how much money companies are selling their preferred stock for.

So let’s say there’s a preferred stock with a $1,000 par value and the company that’s selling it offers a 5% dividend. That means you would receive $50 each year in dividend payments (most likely through quarterly payments of $12.50) for as long as you own the stock.

Preferred stocks have lots of moving parts and pieces, so let’s take a closer look at how preferred stocks work and why they might not be all they’re cracked up to be. 

1. Preferred stocks promise a steady stream of income through dividend payments.

A preferred stock’s dividend payments are usually higher than bond payments and they’re set at a fixed rate, usually somewhere between 5–7%.¹ They’re also paid out before common stock dividends, but after bondholders receive their payments. This makes them very attractive to investors looking to replace bonds that are barely beating inflation with an investment that brings in better returns.

While bonds usually have a start and end date, preferred stocks are perpetual. That means you’ll keep receiving dividend payments as long as you own the stock. Keep in mind that in some cases, however, the company that sold you the preferred stock can buy the stock back from you at its par value after a certain period of time depending on what type of preferred stock you buy. 

But those higher returns come with higher risks . . . risks that don’t make them worth having in your portfolio.

2. Preferred stock payments are not guaranteed.

While a preferred stock might look like a bond and act like a bond, it doesn’t come with the same safety nets and guarantees that a bond does.

Market chaos, inflation, your future—work with a pro to navigate this stuff.

You see, when you buy a bond from a company, that means you’re lending money to that company. That company, then, is obligated to pay you back over time in regular installments (plus interest). If the company misses a payment, then the bond goes into default . . . and that means big trouble for that company. As a bondholder, you can take legal action to make sure you get what you’re owed (but it’s still a massive headache to deal with). 

Preferred stocks don’t have that kind of protection. Since a preferred stock is technically treated like a stock (and not as debt), the company could decide to skip your preferred stock payment and they wouldn’t go into default (it’s rare, but it could happen if the company was in serious financial trouble). And depending on the type of preferred stock you bought, there’s a chance you may never see that payment at all. 

3. Preferred stocks don’t come with voting rights.

Here’s another drawback to preferred stocks: Even though preferred stockholders technically have a piece of ownership in a company, they have no voting rights like common stakeholders do. That means they don’t really get any say in how the company is run.

4. Preferred stock prices are more stable than common stocks.

The price of a preferred stock is much more stable than a common stock’s price, which means you could probably sell a preferred stock for close to the same price you bought it for . . . kind of like a bond.

That stability might be good news if a company’s stock takes a nose dive, but that knife cuts both ways. If you’re invested in preferred stock of a company that cures cancer and the price of its common stock skyrockets, your preferred stock might only jump up a few points.

By choosing the steady income of a preferred stock over common stock, you could be missing out on huge potential profits.

5. Preferred stocks are more difficult to sell than common stocks.

While common stocks can be sold in a matter of seconds, preferred stocks can take days or sometimes even weeks to find a buyer willing to take them off your hands . . . and that’s when things are going well. Good luck trying to sell a preferred stock of a struggling company . . .

Types of Preferred Stock

Not all preferred stocks are created equal! Different types of preferred stocks have their own unique features that impact their level of risk and, in turn, affect how much you can expect to receive in dividend payments. Here are some of the main types of preferred stock to look out for.

Cumulative

Remember how we mentioned that companies might skip a preferred stock dividend payment if they’re running short on cash? Well, cumulative preferred stock offers some protection if that happens.

With cumulative preferred stock, the company promises to pay back any missed payments in the future. So if a company misses three straight dividend payments of $10, that means they would add $30 on top of the next dividend payment owed to you.

Non-Cumulative

That is not the case with non-cumulative preferred stocks. With non-cumulative preferred stocks, those missed payments are gone . . . forever. Since this type of preferred stock is a little riskier, usually the dividend payments will be a little higher than cumulative preferred stocks.

Callable

Callable preferred stock allows a company to buy the preferred stock back from you at a fixed price at some point in the future if it wants to. This usually benefits the company because it limits how high the price of the preferred stock can rise for you, the investor.

For example, let’s say you buy a preferred stock at $25 per share, but the callable stock allows the company to buy it back if it reaches $30 per share. But what if the preferred stock rises to $35 per share? If the stock was bought back by the company at $30, you’ll never have the chance to sell it at $35 per share . . . which would have given you a higher profit.

Convertible

If you ever get tired of owning a preferred stock, some preferred stocks are convertible—which means you have the chance to turn your preferred stock into a certain number of shares of common stock for a price.

Are Preferred Stocks Worth Investing In?

On the surface, preferred stocks have some benefits that might seem more appealing than common stocks or bonds. But when you dig a little deeper, you can see that preferred stocks are really the worst of both worlds—they don’t have the potential for growth that common stocks have . . . and they don’t have the security that makes bonds appealing to some investors.

Your best bet is to steer clear of preferred stocks entirely. They’re just not worth the time, the effort or the risk!

Bonds, meanwhile, offer terrible returns that barely beat inflation while single stocks on their own are just too risky and don’t give you the kind of diversification your investment portfolio needs.

That’s why we recommend investing in good growth stock mutual funds. Most mutual funds have diversification built into them because they contain stocks from dozens or sometimes hundreds of different companies.

To spread out your risk even more, you should invest in four different types of mutual funds: growth, growth and income, aggressive growth, and international. That way, if one company or one sector of the economy tanks, your portfolio won’t go down with it.

Work With a Financial Advisor

If you still have questions about preferred stock or want to get started investing for your future, the best thing you can do is work with a qualified financial advisor. You don’t want just anyone to help you with your investments—you need someone who knows what the flip they’re doing!

That’s what the SmartVestor program is here for. We want to connect you with a financial advisor who can help you make decisions now that will help you build wealth for the future.

Find your SmartVestor Pro today!

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.