Preferred stock is as a stock-bond hybrid, because it shares characteristics of both.
A stock gives one an actual ownership piece in a company. A bond allows one to lend money to a company, receive an interest payment in exchange, and put them in the most advantageous position to get back what they are due if the company files for bankruptcy. In both cases, a company offers these vehicles as a way to finance some activity it wants to engage in.
Preferred stock allows a company to raise money without diluting the ownership of other shareholders, while also allowing current bondholders to maintain their ability to seize the company if something really bad happens to it.
For example, Company X may issue 5,000,000 Series A preferred shares at $20/share to raise $100 million. The price the stock is offered at is called the fixed liquidation value, or par value (just like a bond). So if Company X gets liquidated, due to bankruptcy or similar event, holders of preferred stock should get $20 per share after bondholders get repaid. This is the advantage of preferred stock. Its owners are behind bondholders but ahead of common stock holders. The other advantage of preferred is that the company can miss a payment and not go into default, thereby risking the whole enchilada, as happens with bonds. Instead, unpaid preferred payments often accrue until the company can pay those dividends again.
The trading price of preferred stock is often in a tight range. That’s because they trade more like bonds than stocks — the price often reflects the market’s confidence in the company’s financial strength. You may ask what the point of buying a preferred stock is if the opportunity for capital gains isn’t too great. The answer is that preferred stock pays a dividend, just like a bond interest payment, but that the dividends tend to be much higher than highly-rated bonds. Those bonds reflect little risk so they pay little interest.
This fixed dividend is usually stated as a percentage of the par value — the price at which the preferred stock was issued. Using our example, Company X would issue 5,000,000 shares of 8% Series A preferred Stock at $20/share. This means the preferred shares pay 8% of $20 per year, or $1.60 per share.
As mentioned earlier, if a company is facing a cash crunch, it can suspend the payment of the preferred dividend. With bonds, if a company misses an interest payment, it usually triggers a default on the loan and the company can be taken over by bondholders. But preferred stockholders have no such power. They just hold on and hope the company recovers enough to start paying that dividend again. They also have another advantage over the common shareholders, in that the common stock dividend must be suspended first before the preferred dividend gets altered.
The one other aspect of preferred stock is whether it is callable. “Callable 2014” means Company X’s $20 share price is also the price at which the company could call the stock. That is, beginning in 2014, Company X can buy back the Series A stock at $20 per share, and holders can’t refuse. The company would only do this if the stock trades at over $25, so they’d get it back at a discount to market price, or they think it’s better to spend the $100 million in one lump sum rather than continually paying out dividends.
My pick for the most attractive preferred stock is Ashford Hospitality Trust Preferred D shares. They trade just a little above par, and yield about 8.25%. Ashford is a solid hotel REIT with plenty of liquidity and great management. It was just about the only hotel REIT that did not cut its dividend during the financial crisis.