Similar to common stock, preferred stock is an equity security that represents ownership in a company. Investors typically use preferred stock differently, though. Unlike common stock, preferred stock usually isn’t purchased for capital appreciation (capital gains or growth). Instead, its main value comes from cash dividends.
Some common stocks pay cash dividends, while others don’t. As we learned in the previous chapter, dividend payments depend on the size and overall goals of the company. With preferred stock, you can generally assume dividends will be paid, and the fixed dividend rate is the primary benefit to investors.
The dividend rate is set (fixed) when the security is sold in the primary market by the issuer. Because the payment rate is fixed, 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, although some pay annually or semi-annually. As with common stock, the Board of Directors (BOD) must approve each dividend payment. If the company doesn’t have the funds, the BOD can vote to skip or delay dividends indefinitely. That possibility is a key risk for preferred stock investors (we’ll revisit this in the suitability section).
Issuers sell preferred stock to raise capital 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 small accounting figure with little practical impact. 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 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 these two examples, the dividend rate stayed the same (5%), but the par value changed - so the dollar dividend changed. FINRA questions often test this detail.
At issuance (when the issuer first sells the shares), preferred stock is typically sold at par. After issuance, it trades in the secondary market and its market price can move up or down. Those price changes directly affect the stock’s 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 reflects the return based on what the investor actually pays. Par value stays fixed, but the market price can be above or below par. If a $100 par preferred stock is purchased for $95, the dividend rate is still 5%, but the yield is higher because the investor paid less than par.
Assume the following:
An investor purchases a 5%, $100 par preferred stock for $95
Dividend rate:
Yield:
Yield is often the better snapshot of 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, compare current 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?
Notice the relationship: the higher the price of the preferred stock, the lower the yield. The dividend payment stays $5 per year, but paying more for the same $5 of income reduces the rate of return.
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 influence preferred stock prices, but the main driver is interest rates. Even though preferred stock pays dividends (not interest), its market price tends to move with interest rates because investors compare preferred stock income to bond interest.
To see why, it helps to connect preferred stock to bonds.
Bonds are securities (investments), like preferred stock. They have a par value, can trade at discounts or premiums, and have a fixed payment rate. When an investor buys a bond from an issuer, the investor is essentially lending money to the issuer and receives interest payments over the life of the bond.
When an issuer sets a preferred stock dividend rate, it considers the current interest rate environment because preferred stock competes with bonds for investor capital. If market interest rates are around 5%, it would be difficult to sell a 2% preferred stock. Investors would likely prefer a bond yielding 5%.
Here’s 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 market interest rates at issuance were close to 5%. After issuance, the stock trades in the secondary market. The par value ($100) and dividend rate (5%) stay fixed, but 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 now buy new issues offering around 7%.
To make the 5% preferred stock competitive, its market price would need to fall. When the price of a fixed income investment falls, its yield 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 to $70, the yield rises to 7.14%, which is slightly above the 7% market rate. That higher yield makes the shares more marketable. This is the core relationship: 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 fall to 3%.
In this environment, the 5% preferred stock is more valuable. It still pays $5 per year per share, while new $100 par preferred stock issued today might pay only $3 per year (3%).
Because the 5% dividend is attractive relative to the market, the investor can typically sell the shares for more than $100. Selling above the original purchase price creates a capital gain, which increases the investor’s overall return.
Here’s what happens to current yield when the market 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 increases to $150, the yield falls. It’s still above the 3% market rate, so the shares may remain marketable at this price. This is why fixed income market prices tend to rise when interest rates fall.
Market price changes and yield move in opposite directions:
Most preferred stock is issued with fixed dividend rates, but some issues have variable rates. Adjustable-rate preferred stock (ARPS) (also called variable rate preferred stock) has a dividend rate that typically changes based on the yields of Treasury bills. Because T-bill yields move with interest rates, ARPS dividend rates tend to adjust as interest rates change.
Because the dividend rate adjusts, ARPS market prices tend to stay close to par and are usually less volatile than fixed-rate preferred stock. Fixed-rate securities experience larger price swings because their payments don’t change when market rates change.
The trade-off is that ARPS typically doesn’t rise as much in price when interest rates fall. When rates decline, fixed-rate preferred stock becomes more attractive (its fixed dividend is higher than new issues), so its price may rise more. With ARPS, the dividend rate adjusts downward, which reduces the pressure for the market price to rise.
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 25 quiz questions on this topic