Preferential Treatment for Preferred Stocks?

| Monday, 22 October 2012 18:00
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(eToro Blog)  Equity investors are almost assuredly aware that the majority of stocks traded on the stock markets is of the common variety, but preferred stocks are another option that a trader might consider, though it’s important to understand that they are not simply a better quality stocks. Briefly, preferred stocks are usually offered along with common shares of stock, but in general account for only about 10% of a company’s funding sources and are more often than not issued specifically to underwrite a specific purpose. While a company could issue a bond instead, one benefit to the company which issues them is that they are called or redeemed at the company’s discretion which may be prior to the scheduled maturity.

Preferred stocks have several features that make them unique, but which can be confusing to some investors. First off, some might consider them a hybrid, as preferred stocks share features similar to stocks as well as bonds. They, like a common stock, represent a shareholder’s ownership in a particular company; however, like a bond, the preferred stock pays interest to its shareholder on a regular, pre-determined basis. The disadvantage of issuing preferred stock rather than a bond, from the company’s point of view, is that the interest payment on preferred stocks is not tax deductible, unlike the interest payments on bonds.

Investors might prefer a preferred stock over a common stock for several reasons, not the least of which is that dividends are taxed as ordinary income tax, as opposed to a higher rate for investments. Preferred stocks also tend to be less volatile and less risky than common stocks, because of the regular dividend payments, and because of the guaranteed dividend, it is often held as a fixed-income investment much like a bond.

Another point in favor of the preferred stock occurs when the company decides to stop paying out preferred dividends; because the dividends have been expressly guaranteed, a company must first pay the full amount owed to the preferred stock shareholders even before common shareholders can receive their distribution. Conversely, if the company’s common shares grow in value and the board of directors announces a dividend increase, the company will not be required to increase the dividend payout in a preferred stock.

Solely at the company’s discretion, preferred share can be converted to common shares at a pre-determined price, thus investors will derive a steady dividend stream but have the opportunity to be enriched further if the company grows and its common share prices increase in value.

It’s not all benefits with preferred stock, of course; though similar in nature to a bond they hold more risk as dividends from the preferred stock might be significantly less than an interest payment on a similar bond issuance. While common stockholders interests are subordinate to preferred stockholders’ during periods of financial distress, so too are preferred stockholders subordinate to bond holders. In a bankruptcy or default situation, bond holders would get paid first, followed by preferred stockholders than common stockholders. Last, but not least, preferred stockholders generally have no voting rights unlike common stockholders.

Copyright 2012 eToro Blog

Note: Past performance is not an indication of future results. This post is not investment advice. CFD trading bears risk to your capital.
| Monday, 22 October 2012 18:00
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