Personal Finance: What is a preferred stock?

Today we resume our occasional series on basic investment concepts with an introduction to preferred stocks. These securities have existed since the 19th century but remain a relatively misunderstood asset class. Like any investment, preferreds carry certain risks but can also provide consistent income subject to certain qualifications and the usual caveats relating to understanding the fundamentals.

Until the early 1800s, all shares of a company’s stock were equivalent and paid the same dividend. By 1836, railroads were expanding and needed additional capital. Too much debt would magnify risk, but issuing new stock diluted existing shareholders. The solution was a new class of security called a preferred stock, a hybrid that fell in between bonds and common equities.

Preferred shares (also called “preference shares” in Great Britain) paid a consistent dividend that could not be changed, unlike common stocks. In exchange for this regular income stream, preferred shareholders gave up voting rights. The shares rank higher than common stock but lower than bonds in the order of liquidation if the company stubs its toe. And the issuer is prohibited from paying common dividends until the preferred shareholders are paid.

By the middle of the 20th century, preferred share issue became more popular, especially among companies like utilities that needed to raise expansion capital. While preferreds were originally targeted primarily at large institutions, individual investors became increasingly attracted and issuers created a separate class more attuned to smaller portfolios. Texaco issued the first $25 “retail” preferred share in 1993; today the vast majority sport a face or par value of $25. Most of those issues carry distant maturity dates or none at all, and many may be called by the issuer at will beyond a certain specified date.

Christopher Hopkins

Throughout the 1990s, banks issued boatloads of “trust preferred” securities. Those amounted to bonds in drag; preferred stock issued by a special trust created to hold the bank’s debt. Dodd-Frank regulatory reforms have made these much less attractive to issue and most are gradually being redeemed.