Preferred stock is a hybrid corporate security. It represents an equity interest in the issuing corporation, but unlike common stock, which pays a variable dividend depending on the corporation’s earnings, preferred stock pays a fixed quarterly dividend based on a stated par value. For example, XYZ Corporation might issue preferred stock with a par value of $25.00 and paying a yearly 8% dividend. This would translate into a $2 yearly dividend broken down into four equal payments of 50 cents per share of preferred stock.
Most corporations do not issue preferred shares, but the companies that do usually have good experience with preferred stock and issue multiple classes over time.
When it is first issued, preferred stock’s dividend is determined based on a number of factors including prevailing interest rates. Preferred stocks are usually issued at $25.00 per share. After issuance, the preferred shares trade in the stock market just like common stock. Credit rating agencies rate preferred stocks based on the issuing corporation’s ability to pay dividends. Market prices of highly rated issues tend to fluctuate with interest rates. Prices of lower rated issues – just like prices of lower rated bonds – tend to also fluctuate with the issuing corporation’s fortunes.
With fixed dividends, preferred shares resemble fixed income instruments, however because they don’t mature, they most resemble a perpetuity. Even though it doesn’t mature most preferred stock is callable. Callable preferred stock has an embedded option allowing the issuer to call shares, either at par or at a slight premium above par. In a typical arrangement, shares are not callable for the first few years following issuance, but can be called, perhaps with a month’s notice, any time thereafter. As with callable bonds, the price behavior of callable preferred stocks depends on whether the call option is in-the-money or out-of-the-money as well as the financial strength of the issuer.