Definition and Differences from Common Stock
Preferred stock is a class of shares that carries priority over common stock in dividend distributions and in the distribution of residual assets upon liquidation. In exchange, voting rights are typically limited or absent. Because preferred stock exhibits characteristics of both equity and debt, it is often called a 'hybrid security.'
Preferred dividends are usually set at a fixed rate. For instance, if a preferred share has a par value of 1,000 yen and a fixed annual dividend rate of 5%, it pays 50 yen per year before any dividends are distributed to common shareholders. Even when a company cuts its overall dividend, preferred shareholders are paid first, providing greater income stability.
Types of Preferred Stock and Numerical Examples
Preferred stock comes in 'cumulative' and 'non-cumulative' varieties. With cumulative preferred stock, any unpaid dividends carry forward and must be paid in full before common shareholders receive anything. Non-cumulative preferred stock forfeits unpaid dividends. Investors clearly prefer the cumulative type. Additionally, 'participating' preferred stock entitles holders to extra dividends on top of the fixed rate, alongside common shareholders.
In the U.S. market, preferred stock yields average 5-7%, exceeding both common stock dividends (about 1.5%) and investment-grade corporate bonds (about 5%). In Japan, Ito En's preferred shares (ticker: 25935) are popular with retail investors, offering a 25% higher dividend than the common shares. SoftBank Group also explored issuing Japan's first listed preferred stock in 2023, reflecting growing interest in the domestic market.
Common Misconceptions and Investment Considerations
The biggest misconception is that preferred stock is simply 'safer than common stock.' While preferred shareholders do have dividend priority, in a bankruptcy they rank below bondholders. Creditors are paid first, and preferred shareholders receive distributions only from whatever remains. Furthermore, in a rising-rate environment, the fixed-dividend nature of preferred stock causes its price to fall, exposing holders to interest rate risk similar to that of bonds. Books on income investing provide a comprehensive overview
The key factors for investment decisions are the issuer's creditworthiness and the interest rate environment. Preferred stock from highly rated companies can serve as a stable income source, while preferred stock from weaker issuers carries elevated default risk. Because preferred stock prices decline when rates rise, the rate outlook is also an important consideration. For individual investors, preferred stock ETFs offer a convenient way to achieve diversification.