Preferred stocks combine characteristics of common stocks and bonds. Garden-variety preferred shares are a lot like general obligation bonds/debentures; they are called shares, but carry with them a set dividend, much like the interest on a bond. Preferred shares also do not normally vote, which distinguishes them from the common shares. While today there are a lot of different kinds of hybrid preferred issues, such as a call on the gold production of Freeport McMoran Copper and Gold to the point where they will deliver it, this article will consider characteristics of the most ordinary variety of preferred shares.
In general, a preferred has a fixed dividend (as a bond pays interest), a redemption price (as a bond), and perhaps a redemption date (like a bond). Unlike a stock, it normally does not participate in the appreciation (or drop) of the common stock (it trades like a bond). Preferreds can be thought of as the lowest-possible grade bonds. The big point is that the dividend must be paid from after-tax money, making them a very expensive form of capitalization.
One difference from bonds is that in liquidation (e.g. following bankruptcy), bond holder claims have priority over preferred shares, which in turn have priority over common shares (in that sense, the preferred shares are “preferred”). These shares are also preferred (hence the name) with respect to payment of dividends, while common shares may have a rising, falling or omitted dividends. Normally a common dividend may not be paid unless the preferred shares are fully paid. In many cases (sometimes called “cumulative preferred”), not only must the current preferred dividend be paid, but also any missed preferred dividends (from earlier time periods) must be made up before any common dividend may be paid. (My father once got about a $70 arrearage paid just because Jimmy Ling wanted to pay a $0.10 dividend on his common LTV shares.)
Basically, preferreds stand between the bonds and the common shares in the pecking order. So if a company goes bankrupt, and the bond holders get paid off, the preferreds have next call on the assets – and unless they get something, the common shareholders don’t either.
Some preferred shares also carry with them a conversion privilege (and hence may be called “convertible preferred”), normally at a fixed number of shares of common per share of preferred. If the value of the common shares into which a preferred share may be converted is low, the preferred will perform price-wise as if it were a bond; that is often the case soon after issue. If, however, the common shares rise in value enough, the value of the preferred will be determined more by the conversion feature than by its value as a pseudo-bond. Thus, convertible preferred might perform like a bond early in its life (and its value as a pseudo-bond will be a floor under its price) and, if all goes well, as a (multiple of) common stock later in its life when the conversion value governs.
And as time has gone on, even more elaborate variations have been introduced. The primary reason is that a firm can tailor its cost of funds between that of the common stock and bonds by tailoring a preferred issue. But it isn’t a bond on the books – and it costs more than common stock.
In general, you won’t find a lot of information on the preferred shares anywhere. Since they are in a never-never land, it is hard to analyze them (they are usually somewhere low on the equity worth scale from the common and bonds). So they can’t really carry a P/E and the like. Unfortunately, most come with the equivalent of the bonds indenture – that is the “fine print” and you may have to get and read it to see just what you have. (I once had preferreds that paid dividends in more shares of itself and in shares of another preferred, but how Interco got itself into bankruptcy is another story.)
There are other reasons why preferreds are issued and purchased. A lot of convertibles are held by people who want to participate in the rise of a hot company, but want to be insulated from a drop should it not work out. Here’s a different strategy. For example, I’ve got some Williams Brothers Preferreds. They pay about 8.5% and are callable in Fall, 1997. When I bought them (some years ago), they had just been issued and were unrated (likely still are not). But Williams itself is a well-run company with strong cash flow that then needed the money fast to buy out a customer who was in trouble. So I bought these shares more as I’d buy a CD. The yield is high, the firm solid – and likely they will pull my investment out from under me someday. Meanwhile, it forms a bit of my “ready cash” account. And I can always sell it if I want to.
Problem is, with so many variants, there isn’t always a preferred that you’d want to buy at the current price to carry out some specific strategy. Naturally, not every firm has them, the issues are often thinly traded and may not trade on the exchange of the parent firms common (or even be listed on any exchange).
If the preferred shares get called (i.e., converted), you normally collect just as if common shares are bought out – in cash, no deduction.
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Contributed-By: John Schott