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 and selling high) isn’t the main reason most investors buy preferred stock (even though it can happen). The primary value comes from cash dividends.
Some common stocks pay cash dividends, while others don’t. 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 main 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 amounts 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 payment 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 revisit 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 a minor accounting figure. For preferred stock, par value is very important because the annual dividend amount (the main reason many 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 state a par value. 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 these two examples, everything was the same except par value, and that single change produced a different total dividend. On exam questions, assume par is $100 only when it isn’t stated - but don’t assume it’s always $100.
At issuance (when the issuer first sells it to investors), preferred stock is typically sold at par. Once it trades in the secondary market, its market price can move up or down, and that price movement directly affects yield.
Yield is a term commonly used with bonds, but it applies to any income-producing investment. The dividend rate tells you what percent of par is paid each year. For example, a 5%, $100 par preferred stock pays $5 per year. That 5% is the dividend rate, but it isn’t necessarily the yield.
Yield considers what the investor actually paid. Par value stays 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 is a more accurate measure of the investor’s return. Paying $95 and receiving $5 per year is a 5.26% return on the amount invested.
Now compare current yield 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?
The key relationship is:
The higher the price of the preferred stock, the lower the yield.
In all cases here, the investor still receives $5 per year. When the purchase price rises, that same $5 represents a smaller return on the dollars invested.
Finance professionals often describe market prices relative to par:
| 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 affected by interest rate changes because investors compare preferred stock to other income investments.
To see why, it helps to connect 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 it’s competing with bond issuers for investor capital. If the average interest rate is 5%, it would be difficult to sell a 2% preferred stock. Investors would likely prefer a bond yielding 5%.
Now 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 stock trades 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, it may be hard to find a buyer because investors can buy newly issued 7% bonds or preferred stock.
To attract buyers, the market price of the 5% preferred stock 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 rate. That higher yield makes the preferred stock more marketable. This is why fixed-income market values tend to fall when interest rates rise.
Now consider falling interest rates.
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 fell to 3%.
In this environment, the 5% preferred stock is more valuable. It pays $5 per year per share, while newly issued $100 par preferred stock might pay only $3 per year (3%).
Because the 5% dividend is attractive relative to the 3% market, the investor can typically sell for more than $100. If the investor sells above the original purchase price, the investor earns a capital gain, increasing the overall return.
Here’s what happens to current 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 rises to $150, the yield falls. It’s still above the 3% market rate, so the preferred stock can remain marketable even at this higher price. 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 based on the price paid.
When an investor buys or sells shares of preferred stock, the settlement timeframe is the same as common stock. Regular-way trades settle in one business day (T+1), while cash settlement trades settle the same day (as long as before 2:30pm ET).
Sign up for free to take 9 quiz questions on this topic