How they Work
Unlike common shares, preferred shares don’t give you the right to share in a company’s fortunes. Your rights end at getting a set amount of dividends and having a prior claim on the company’s assets ahead of common shareholders if the firm goes out of business. Only if the company misses a set number of dividend payments do preferred shareholders have a right to vote in the company’s affairs. If the company earns a profit again, preferred shareholders are usually entitled to get all the missed dividend payments paid to them before common shareholders get any. Those that don’t have this provision are called non-cumulative preferreds. In many ways, preferred shares are like bonds, except that they don’t have a set maturity date. They are often issued at a face value, usually $25, $50 or $100. The fixed dividend payments – mostly paid every three months – are like a bond’s interest payments. And they react the same way to changes in interest rates as bonds do. If interest rates go down, preferred share prices go up, and vice versa.
Since preferred share prices react to swings in interest rates, you could get less than you paid for your shares if interest rates rise and you have to sell. This is because the yield on your preferreds likely won’t be competitive with other investments now that rates have gone up. You will likely have to drop the price so that the fixed dividend gives prospective buyers an attractive return. There’s also the risk that the company will do badly and not have money to pay dividends. If this happens, you might also have to sell your shares at a loss. Other investors won’t be interested in a preferred share that isn’t paying dividends. If the company goes bankrupt, you’ll likely lose money on your preferreds, but likely less money than if you’d bought the firm’s common stock. Preferreds entitle you to a set amount of money if the company goes bust. However, you’ll only be paid after bond holders and other creditors have been paid, which mean there might not be much left.
Yields on many preferred shares are higher than those of other fixed-income investments like bonds. This is because the return is less assured so the higher yield compensates you for taking on the added risk. Since preferred prices respond in opposite directions to interest rates, you can make a profit by selling them after interest rates have gone down. The income you get from the preferred share’s dividend is taxed less heavily than interest on bonds, leaving you with a bigger actual return.