Similar to common stock, preferred stock is an equity security that represents ownership in a company. Investors typically use preferred stock differently, though. Capital appreciation (capital gains, growth, buying low & selling high) isn’t the main reason most investors buy preferred stock (even though it can happen). Instead, preferred stock is valued primarily for its cash dividends.
Some common stocks pay cash dividends, while others do not. As we learned earlier in this unit, dividend payments depend on the size and overall goals of the company. With preferred stock, you can generally assume dividends are paid, and the dividend rate is the primary benefit to investors.
The dividend rate is fixed (it doesn’t change) when the security is sold in the primary market by the issuer. That’s why preferred stock is often treated as a fixed income security. This differs from common stock, where dividend rates can change over time.
Preferred stocks typically pay cash dividends quarterly, but you may also see annual or semi-annual payments. As with common stock, the Board of Directors (BOD) must approve each dividend when it’s due. If the company doesn’t have the funds, the BOD can vote to skip or delay dividends indefinitely. That creates risk for investors, which we’ll explore further in the suitability chapter later in this unit.
Issuers sell preferred stock to raise capital (money) from investors. At issuance, the stock is assigned a par value (also called face value). Par value matters because the dividend rate is applied to par.
For example:
An investor purchases 100 shares of a $100 par, 5% preferred stock. What is the annual amount of dividends received?
Can you figure it out?
Answer = $500
To find the annual dividend paid to the investor on a per-share basis, use this formula:
If every share pays $5 in annual dividends, then 100 shares will pay a total of $500 ($5 x 100 shares).
All forms of stock have a par value, including common stock. For common stock, par value is usually an insignificant number used mainly for accounting. For preferred stock, par value is very important because the annual dividend amount (the main reason investors buy preferred stock) is based on par.
The typical par value for preferred stock is $100, and you should assume $100 if an exam question doesn’t specify otherwise. However, other par values exist, including $25 and $50.
Here’s how a different par value changes the payout:
An investor purchases 100 shares of a $25 par, 5% preferred stock. What is the annual amount of dividends received?
Answer = $125
To find the annual dividend paid to the investor on a per-share basis, use this formula:
If every share pays $1.25 in annual dividends, then 100 shares will pay a total of $125 ($1.25 x 100 shares).
In the two examples above, everything stayed the same except par value, and that alone changed the total dividends. Pay close attention to par value in exam questions. Assume $100 only when par isn’t stated.
At issuance (when the issuer first sells the shares), preferred stock is typically sold at par. Once it trades in the secondary market, its market price can move up or down, and that directly affects its yield.
Yield is a term often used with bonds, and it describes the overall rate of return on an income-producing investment. With preferred stock:
For example, a 5%, $100 par preferred stock pays $5 per year. The 5% is the dividend rate, but it isn’t necessarily the yield.
Yield considers the price paid, while the dividend rate does not. Par value is fixed, but the market price can be higher or lower than par depending on demand. So if a $100 par preferred stock is purchased for $95, the dividend rate stays the same, but the yield changes.
Assume the following:
An investor purchases a 5%, $100 par preferred stock for $95
Dividend rate:
Yield:
As you can see, yield better reflects the investor’s return. If the investor pays $95 and receives $5 per year, the return based on the amount invested is 5.26%.
Now, let’s compare yields at different market prices.
An investor purchases a 5%, $100 par preferred stock
What’s the current yield if purchased for $100?
And for a market price of $105?
As you can see, the higher the price of the preferred stock, the lower the yield. We used current yield, which is based on the current market price. In all cases here, the investor still receives $5 per year in dividends. The more the investor pays for that same $5 of annual income, the lower the yield.
Finance professionals often describe market prices using these terms:
| Trading at… | Relationship |
|---|---|
| Discount | yield > dividend rate |
| Par | yield = dividend rate |
| Premium | yield < dividend rate |
Many factors can affect the market price of preferred stock, but the main influence is interest rates. Even though preferred stock pays dividends (not interest), its market price is strongly influenced by interest rate changes because preferred stock competes with other income investments.
To see why, it helps to compare preferred stock to bonds.
Bonds are securities (investments), just like preferred stock. They have a par value, can trade at discounts and premiums, and have a fixed payment rate. When an investor buys a bond from an issuer, the investor receives interest over the life of the bond. In other words, the investor is lending money to the issuer in exchange for interest payments.
When an issuer sells preferred stock, it considers the interest rate environment because preferred stock competes with bonds for investor capital. If the average interest rate is 5%, it would be difficult to sell a 2% preferred stock. Why buy a preferred stock yielding 2% when a bond yields 5%?
Let’s walk through how interest rate changes affect preferred stock market prices.
Assume the following:
An investor buys a newly issued 5%, $100 par preferred stock at par.
It’s reasonable to assume the average interest rate at issuance was close to 5%. Preferred shares are typically issued at par with a dividend rate that reflects current interest rates. After issuance, the shares trade in the secondary market. The par value ($100) and dividend rate (5%) stay fixed. The market price can change.
If interest rates rise to 7%, the 5% preferred stock becomes less attractive. If the investor tries to sell at $100, finding a buyer may be difficult because investors can now buy newly issued 7% bonds or preferred stock.
To make the 5% preferred stock attractive again, its market price must fall. When the price of a fixed-income investment falls, its yield (overall rate of return) rises.
An investor buys 100 shares of a newly issued 5%, $100 par preferred stock at par. Interest rates rise to 7% and the investor attempts to sell the stock for $70 per share. What is the current yield for the investment?
By lowering the price, the yield rises to 7.14%, which is now slightly above the 7% market interest rate. That higher yield makes the preferred stock more marketable, which is why fixed-income market values tend to fall when interest rates rise.
Now consider what happens when interest rates fall.
Assume the following:
An investor buys a newly issued 5%, $100 par preferred stock at par when interest rates are averaging 5%. A few years later, interest rates fall to 3%.
In this environment, the 5% preferred stock is more valuable. It still pays $5 per year per share, while newly issued $100 par preferred stock would pay only $3 per year (3%).
Because the 5% preferred stock is in demand, the investor can ask for more than $100 per share. Selling above the original purchase price creates a capital gain and increases the investor’s overall return.
Here’s what happens to yield when the price rises:
An investor buys 100 shares of a newly issued 5%, $100 par preferred stock at par. Interest rates fall and the investor attempts to sell the security for $150 per share. What is the current yield?
Can you figure it out?
Answer = 3.33%
When the price increased to $150, the yield fell. However, it didn’t drop below the current market interest rate of 3%. The preferred stock is still marketable at this price, and the investor could even consider raising the price further. This is why market prices tend to rise when interest rates fall.
Market price changes directly affect preferred stock yields:
Yield is a measure of a preferred stock’s overall return.
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