1.3 Preferred Stock

What Is Preferred Stock?

Preferred stock is a hybrid security blending equity and debt traits. It pays a fixed dividend, usually expressed as a percentage of a $100 par value (the Series 7 default) or as a dollar figure, and it ranks ahead of common stock for both dividends and liquidation proceeds. It still sits behind all bonds and creditors, however.

A $100 par, 5% preferred pays $100 × 5% = $5 per year, typically in quarterly installments of $1.25. Preferred dividends, like common dividends, must be declared by the board — they are not contractual the way bond interest is.

Preferred vs. Common vs. Bonds

Because preferred behaves like a fixed-income instrument with no maturity, its price is highly sensitive to interest rates.

Types of Preferred Stock

Cumulative Preferred

Cumulative preferred is the default and most common type. Any skipped dividends accumulate as dividends in arrears and must be paid in full before common holders receive a cent. A $4 cumulative preferred that skips two years owes 2 × $4 = $8 in arrears plus the current $4, so $12 total per share, before any common dividend.

Non-Cumulative (Straight) Preferred

With non-cumulative preferred, skipped dividends are gone forever — there is no make-up obligation. This makes it less valuable than cumulative preferred, all else equal.

Callable Preferred

Callable preferred lets the issuer redeem shares at a stated call price (typically par or slightly above) after a set date. Issuers call when rates have fallen, refinancing at a cheaper dividend. The investor bears call risk: the income stream can be terminated just when reinvestment rates are unattractive. Callable preferred therefore offers a slightly higher dividend to compensate.

Convertible Preferred

Convertible preferred can be exchanged for a fixed number of common shares at the holder's option, giving equity upside. The conversion ratio states the common shares received per preferred share.

$\text{Parity Price} = \text{Common Price} \times \text{Conversion Ratio}$

If a 5:1 convertible preferred trades at $80 while common is $18, parity = 5 × $18 = $90. Because parity ($90) exceeds the preferred's $80 price, converting (or arbitraging) is profitable. Convertible preferred usually pays a lower dividend than straight preferred, the trade-off for the conversion privilege.

Participating Preferred

Participating preferred receives the stated dividend plus extra distributions when profits exceed a threshold, letting holders "participate" in upside alongside common. It is rare but tested.

Adjustable-Rate (Floating-Rate) Preferred

Adjustable-rate preferred resets its dividend periodically against a benchmark (such as a Treasury yield). Because the payout floats with rates, its price stays comparatively stable — a key point: floating-rate preferred is the least interest-rate-sensitive variant.

Interest-Rate Sensitivity

Fixed-rate preferred moves inversely with interest rates, just like bonds:

• Rates rise → existing preferred prices fall.
• Rates fall → existing preferred prices rise.

A 5% preferred becomes unattractive when new issues yield 6%, so its price slides until its current yield is competitive.

Current Yield on Preferred

The exam frequently asks for the current yield, computed on the annual dividend and market price, not par:

$\text{Current Yield} = \frac{\text{Annual Dividend}}{\text{Market Price}}$

A $100 par, 6% preferred pays $6 a year. If it trades at $80, the current yield is $6 ÷ $80 = 7.5% — higher than the 6% stated (nominal) rate because the investor pays less than par. If it trades at $120, current yield is $6 ÷ $120 = 5%. Watch for distractor answers that divide by par; always use market price for current yield.

Prior Preferred and Other Variants

Prior (senior) preferred ranks ahead of other preferred issues for dividends and liquidation — useful when a company has layered several preferred classes. The exam may describe a situation where one preferred class must be paid before another; that senior class is the prior preferred. Combining features is common too: an issue can be cumulative, callable, AND convertible at once, so read each described feature independently rather than assuming a single label.

Why Preferred Sits Between Bonds and Common

Preferred dividends are paid from after-tax earnings, so they are not tax-deductible to the issuer — unlike bond interest, which is deductible. That makes preferred a more expensive financing tool than debt for the company, but it avoids the fixed maturity and default risk of a bond. For investors, the trade-off is income priority over common in exchange for surrendering most voting rights and upside. Suitability questions test that preferred suits income-focused investors who want more safety than common but accept rate-driven price swings.

Investor Trade-Offs

Exam Focus

• Identify the variant from its description (cumulative, callable, convertible, participating, adjustable).
• Compute dividends in arrears on cumulative preferred.
• Parity price = common price × conversion ratio.
• The inverse rate relationship — and that adjustable-rate preferred is least rate-sensitive.
• Priority sequence: bonds → preferred → common.