What Are Preferred Stocks? Limited Risk with Limited Gains
Investors who purchase shares of preferred stock receive income before shareholders who own common stock. Unlike common stock owners, preferred shareholders do not have the right to vote on company matters. Investors who buy preferred shares typically want income but do not necessarily seek to profit from the long-term success of the issuing company. According to FINRA, preferred stock presents less risk than common stock but has a lesser chance of significant returns. The Wall Street Journal reports that preferred stocks have recently underperformed the returns offered by the S&P 500 and U.S. long-term bonds. Nevertheless, investors may be tempted by high dividends. Preferred usually pay dividends of 6% to 7%.
Even if you did not lose money on a preferred stock, it still may not be the right product for you. Certain investments come with an opportunity cost—money you lose by not investing your money in a security with better returns. Brokers should only recommend investments that fit your financial goals. If you want to make more money in the long run, preferred stock is probably not the best choice, and your brokerage firm could be liable for your losses if your broker misrepresented preferred shares.
How Does Preferred Stock Work?
Like bonds, preferred shares have a face value, also known as a “par value.” The dividends are calculated as a percentage of the par value. Preferred stockholders must be paid their distributions before common stockholders.
Depending on the issuer, investors may be able to convert preferred shares to common shares. Investors should be sure to know if they have this option because preferred stocks often do not have maturity dates.
Preferred shares may come with a guaranteed dividend that continues indefinitely. This is a fixed dividend that does not increase as the stock’s value increases. On the plus side, the value of preferred shares does not decline with the price of the common stock shares.
Preferred Stock Voting Rights
Investors who purchase preferred stock have to settle for a hands-off relationship with the issuing company. Shareholders in common stock can get more involved in the company’s management. Voting rights allow common stock investors to vote on company issues, like whether the company should acquire another business.
Risks of Preferred Shares of Stock
Preferred shares are actually “callable,” which means that the issuer can redeem them after a predetermined period. It may be in the issuer’s best interest to call back the shares in order to stop paying dividends. Investors in preferred shares stand to enjoy a substantial profit, assuming the face value of the shares has increased from the time of purchase.
- Calls are less likely when interest rates rise. When interest rates rise, however, investors might regret missing out on the stronger returns offered by common stock. Rising interest rates make the value of the preferred shares decline.
- Issuers may want to call the preferred shares if interest rates have gone down, making it possible for companies to issue preferred shares at lower interest rates.
- The issuers’ creditworthiness may also affect the preferred shares’ value.
- Preferred stock does not always come with a maturity date. If an investor wants to get their principal back, they will have to try to sell their shares on a secondary market.
When is Preferred Stock a Risky Investment?
Preferred stocks are not all created equally. Brokerage firms should carefully research the issuing company and the specific terms of a preferred stock.
- FINRA fined a broker after she recommended preferred shares of a distressed energy company that specifically stated in their prospectus that any money raised from preferred stocks would go toward paying off debt. In fact, a credit rating company had rated this investment as speculative. This high-risk investment did not suit the investor’s financial needs, and the broker was fined $10,000 and had to requalify as a broker by taking the Series 7 exam.
- FINRA alleged in an Acceptance, Waiver, and Consent agreement that a brokerage firm called Capital City had failed to perform its due diligence before they recommended preferred shares of a high-risk private placement. According to the AWC, FINRA’s due diligence consisted solely of a link to the private placements’ Edgar filing. Anyone can access an Edgar filing — investors should be able to rely on their brokers to provide more sophisticated insights.
- In another Acceptance, Waiver, and Consent agreement, FINRA fined a broker after attempting to resolve a dispute with an investor over preferred shares. The preferred shares had stopped distributing dividends, and to placate the investor, the broker tried to pay the investor themselves, which goes against FINRA regulations.
Preferred Stock Fraud
Contact an investment lawyer if you believe your preferred stock shares did not perform as expected. Private placements might sound like a reliable source of income, but they are only as solid as the issuing company. It is your broker’s duty to research preferred stocks and verify they suit your financial goals. If they did not perform their due diligence, our attorneys can help you recover your losses through FINRA arbitration.