Preferred stock

A preferred stock, also known as a preferred share or simply a preferred, is a share of stock carrying additional rights above and beyond those conferred by common stock. These rights include priority in receiving dividends and precedence (after creditors) over common stock shareholders in claims to corporate assets upon liquidation.

Characteristics
However in return for these benefits, preferred stock has limited upside. The stock is normally issued at a fixed price (say $10.00 per share) paying a fixed dividend (say $0.60). The price of the shares will fluctuate with interest rates-- down if interest rates go up, up if they go down, like bonds. They will also fluctuate with the perceived financial health of the issuer. If the stock is called or redeemed investors will normally only get par value (ie $10.00 per share). Examples of situations that would cause this to occur include: if the stock is redeemed by the investor (if it has such a provision); called by the issuer (many of them include a call provision allowing the issuer to call them early at its discretion); or the issuer is taken over or liquidated.

As an investment
Preferred stock, as a yield investment, acts similar to a fixed income security, the price reacting primarily to changes in interest rates. Preferreds often do sport high yields, but in addition to interest rate risk, they're usually subject to call risk and nontrivial credit risk. Some preferreds pay qualified dividends, currently taxable to individuals at a maximum 15% rate.

Preferred stock (or shares) was once widely issued to investors seeking yield. However since the late 1970s it has become possible for most companies to issue high yield (junk) bonds, which have many of the same characteristics of preferred stock but where the interest coupon paid is deductible from corporate taxes. Therefore this is a more efficient form of finance from the perspective of the issuer.

The exception to this general rule is in the case of some financial stocks, particularly banks. Regulators require financial companies to have a certain amount of capital, to shield depositors against losses on their assets such as bad loans. In the balance sheet formula Assets (such as loans and mortgages for a bank) = Liabilities (Depositors and bonds) + Equity. Bank leverage (the ratio between Assets and Equity) is limited to certain maximums by regulators. Included in regulatory capital is common stock (ordinary shares), retained earnings and some forms of securities including hybrid bonds and preference stock (or preference shares). So financial institutions issue preference stock to boost their capital and reduce their leverage.

Performance
The performance of preference stock tends to track the performance of bonds issued by the same company, reflecting both the general level of interest rates and the market's view of the financial health of a company. If a company becomes financially distressed or bankrupt, then a restructuring is likely. Because preference shareholders rank behind debt holders (such as bond investors) in the sale or liquidation of the company, they usually get very little or nothing if there is a bankruptcy situation. In addition, if the company becomes financially distressed, the directors may deem it prudent that the company not pay any preference dividends-- prefererred shareholders have limited legal rights in such a situation, whereas bondholders facing a skipped interest payment have the rights of creditors.

In a sense then preference stock often combines the worst features of corporate bonds (frequently callable; lack of upside) with those of common stock (little protection in bankruptcy; possibility dividend will be omitted). In addition portfolios of preference shares are highly concentrated around financial companies, thus reducing diversification.

Role in a portfolio
For the reasons above, investment in preference stock is usually not recommended. The risk-return tradeoffs are unfavourable for individual investors and those seeking corporate credit risk exposure are better advised to invest in corporate bond funds, whilst those seeking equity upside are advised to invest in diversified index funds made up of common stock (like Vanguard Total Stock Market).

Convertible stocks
Companies do issue convertible preferred stock, which is stock which carries a right to convert into common stock at a certain pre-specified exercise (or strike) price. The analysis of the value of this option (effectively a long dated call option) to the investor is complex and it is a relatively risky area that requires expertise to make successful investments.

Venture capital issuances
Preference stock is also issued in venture capital deals. Venture capital funds invest into private companies to accelerate their growth, with the eventual goal of a sale to a trade buyer or an IPO. Typically they invest in "rounds" (A Round, B Round, etc.) and do so using preference shares (which usually have the right to convert to common stock on sale or IPO of the business, thus giving investors a degree of downside protection but full participation in the upside). Such investments are totally illiquid unless there is a realization event such as a sale of the business, which may take many years. Venture capital investing is a very risky area requiring specialized skills and generally should be avoided by anyone who cannot afford to lose all of his or her investment in a given company.

Mutual funds
The most attractive current products investing in preferreds are in the form of exchange traded funds.
 * PFF: iShares S&P U.S. Preferred Stock Index Fund (expense ratio 0.48%)
 * PGX: PowerShares Preferred Portfolio (expense ratio 0.50%)
 * PGF: PowerShares Financial Preferred Portfolio (expense ratio 0.60%; invests only in securities which pay qualified dividends)

The open-end Vanguard Preferred Stock Fund, advised by Wellington Management Company, existed from 1975 until its liquidation in 2001. Reasoning behind the termination appears the fund's semiannual report of 04/30/2001.

"As you know, Vanguard Preferred Stock Fund's board of trustees has decided to close and liquidate the fund. On July 27, the fund's assets will be distributed to investors. In preparation for the closing, the fund stopped accepting new accounts and additional investments on April 6."

"After careful consideration, the board decided that liquidating the fund was in the best interest of its shareholders. When the fund was launched in 1975, corporations that invested in certain preferred stocks were permitted to deduct 100% of the income they received--a feature that made these preferreds, and mutual funds devoted to them, an attractive  investment for many companies. Though the deduction was later reduced to 70%, preferreds continued to make sense for many corporate investors. Ultimately, however, the lower deduction--combined with the introduction of other securities that offered more appealing tax breaks to corporations--resulted in a severe drop-off in the issuance of preferred stocks that were eligible for the federal intercorporate dividends-received deduction (DRD)."

"The fund made several moves to adapt to the changing environment--for example, in March 2000 the board of trustees broadened the fund's investment options by allowing the adviser to purchase non-DRD-eligible securities. However, the board finally concluded that the changes in the market made it unlikely that investor interest in the fund would revive."

Investopedia

 * Preferred Stock
 * Callable Preferred Stock
 * Convertible Preferred Stock
 * Participating Preferred Stock
 * Cumulative Preferred Stock