What is preferred stock?

Preferred stock shares are issued by a company as debt instruments, much like corporate bonds. The company promises to repay the money lent by the investor and to pay interest (usually quarterly) to the preferred shareholder in the form of dividends.

The first group of stock a company issues is common stock; a company may then issue preferreds. Preferred-stock holders get “preferred” treatment over common-stock holders: Only after preferred-stock holders have received their dividends do common-stock holders receive any dividends. If a company should go bankrupt, preferred-stock holders will receive principal before common-stock holders, but after creditors and bondholders.

If interest rates fall, the issuing company must still pay out fixed preferred dividends. The prices of common stocks rise and fall with market conditions, but preferred-stock holders receive a fixed dividend year after year. Generally, this leads to greater price stability with preferreds than with common-share ownership.

Preferreds have similar characteristics to bonds, but there are several differences that will affect you and the issuing corporation. Bonds are simply IOUs issued with a promise to repay by a certain date. Both bonds and preferreds pay a specific dollar amount each year. From a tax standpoint, companies would rather issue bonds.

New issues are regularly offered with five-year call protection. That means the issuing company can’t pay off the loan (and must continue to pay you interest for at least five years). Brokers may try to convince you to sell a preferred at a profit rather than let it get called away from you at the call price. Most often, this advice is unable to stand up to mathematical testing.

Most preferreds are NYSE-listed and trade just like common stocks. You can open The Wall Street Journal any day of the week, turn to the NYSE stock listings, and find your preferred stock. Your issue has solid visibility.

So, here are the guts of how to play the preferred game. Let’s say you buy a new issue 7% preferred at the usual $25 with normal five-year call protection. Your preferred’s management cannot call your issue away from you for five years, and then only at $25 a share. And the entire time, you collect 7% per year, regardless of what the stock market does.