Preferred stock represents ownership and is an equity security (like common stock), but it behaves more like a fixed-income security (unlike common stock). It’s best known for dividend income, which is typically static (fixed) and doesn’t change. For context, dividend payments from common stock typically fluctuate over time. While only certain companies pay cash dividends on their common stock, all companies pay cash dividends on their preferred stock.
We’ll cover the essentials of preferred stock in this chapter, including:
Dividend payments are the main attraction of preferred stock. Preferred stock typically pays cash dividends quarterly, although some issuers choose annual or semi-annual payments*.
Just like common stock dividends, the Board of Directors (BOD) must approve each dividend payment.
*In test questions, assume preferred stock pays quarterly dividends unless otherwise specified.
The term ‘par’ matters any time you’re working with fixed-income-style investments like preferred stock and bonds. Par value is also called face value (like the face value printed on a concert ticket).
Concert tickets might start out selling at face value, then trade in the secondary market. If demand is high, tickets trade above face value. If demand is low, they trade below face value. Preferred stock prices can behave the same way.
When preferred stock is originally issued, it’s typically sold at its par value. For exam purposes, you should assume preferred stock has a par value of $100, although some issuers use different par values (e.g., $25 or $50*).
*In test questions, assume preferred stock par value is $100 unless otherwise specified.
Par value is crucial because it determines the dividend amount paid to investors. Preferred stock has a fixed dividend rate, sometimes called a “coupon*.” The dividend rate is always based on par.
For example, assume ExxonMobil issues a $100 par, 5% preferred stock. Shares are sold at par ($100) and will pay $5 per year to investors (5% of $100). Since preferred stock typically pays quarterly, investors receive $1.25 per share every three months.
The key point: preferred stock dividends are always based on par, even if the market price changes.
*The reason we refer to the income rate of fixed income securities as “coupons” is covered later in this material.
Most preferred stocks are originally issued at par in the primary market. After issuance, they trade in the secondary market. In the secondary market, the price moves based on supply and demand.
Even if the market price changes, par value and the dividend rate do not. Using the ExxonMobil example, the dividend rate stays 5% of $100 par, whether the market price is $80, $110, or anything else. The stock still pays $5 per year.
The issuer’s profitability can also affect the market price. Since the main value of preferred stock is its dividend payments, a less profitable issuer (or one that’s less likely to pay dividends) will generally have less valuable preferred stock, and the market price may fall.
Yield is the rate of return an income-producing security provides.
Yield matters because it reflects what the investor actually paid. The dividend rate doesn’t.
To see the difference, assume:
An investor purchases a 5%, $100 par preferred stock purchased in the secondary market for $80.
Dividend rate:
Yield:
The current yield (also called the dividend yield) is the most common way investors estimate return on income-producing securities. It’s called current yield because it uses the current market price.
In the example above, the investor still receives $5 per year (5% of $100 par). But because they paid only $80, their personal rate of return is higher: 6.25%.
Now let’s see how yield changes as market price changes.
An investor purchases a 5%, $100 par preferred stock purchased in the secondary market for $100. What’s the current yield?
And the current yield if the market price of the security is $120?
This shows the basic relationship: as the preferred stock’s market price rises, its yield falls (and vice versa). The dividend stays $5 per year, but the return rate depends on how much the investor pays.
Finance professionals often describe prices relative to par:
To summarize how price relates to yield:
| Trading at… | Relationship |
|---|---|
| Discount | yield > dividend rate |
| Par | yield = dividend rate |
| Premium | yield < dividend rate |
The current yield formula is important because it gives a quick way to estimate a customer’s overall rate of return based on the price they pay.
Preferred stock is a negotiable security, meaning it trades in the market and its price can fluctuate. Like other negotiable securities, its market price is driven by supply and demand.
However, preferred stock prices are usually influenced less by day-to-day business conditions than common stock prices. Instead, preferred stocks are most commonly influenced by interest rate changes.
An interest rate is the cost of borrowing money. It matters because borrowing is everywhere:
Preferred stock doesn’t pay interest (interest is tied to borrowing), but its market price is still heavily influenced by interest rate changes. That’s because the dividend rate on preferred stock competes with interest rates available elsewhere.
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 make semi-annual payments. The key difference is that bonds are debt securities. When investors buy bonds in the primary market, they’re essentially lending money to the issuer. In return, they receive interest over the life of the bond.
Because bonds and preferred stocks share many features, they often compete for the same investors. That means bond market conditions matter when a corporation issues preferred stock. For example, if the average bond interest rate is 7%, it would likely be difficult to issue a 3% preferred stock. Investors would ask: why accept 3% when a similar bond offers 7%?
Because of this competition:
Once preferred stock is issued, its dividend rate is fixed. After that, market price does most of the adjusting when interest rates change.
Let’s walk through an example.
Assume the following:
An investor buys a newly issued 5%, $100 par preferred stock at par.
It’s common for preferred stock to be issued at par with a dividend rate that reflects current interest rates. So assume market interest rates were around 5% at issuance.
If interest rates later rise to 7%, the 5% preferred stock becomes less attractive. If the investor tries to sell it for $100, they may struggle to find a buyer - because new buyers can now get a 7% bond or preferred stock.
To sell the 5% preferred stock, the investor can lower the price. When the market price of a fixed-income-style investment falls, its yield rises for the buyer.
An investor purchases 100 shares of a newly issued 5%, $100 par preferred stock at par. Interest rates rise to 7%, and the investor attempts to liquidate 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 competitive with the 7% market rate. This is why fixed-income market values tend to fall when interest rates rise.
Now consider the opposite situation.
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%.
Now the 5% preferred stock is more valuable. New fixed-income investments are offering around 3%, but this preferred stock still pays 5% of par.
That means the investor may be able to sell the preferred stock at a premium. If they offered it at $100, it would likely be purchased quickly. This is a common way a preferred stockholder can earn a capital gain.
Here’s what happens to 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 offers to sell the security for $150. What is the current yield?
When the price rises to $150, the preferred stock’s yield falls to 3.33%. It’s still above the 3% market rate, so the preferred stock remains marketable at that price.
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