Preferred Shares Definition

As a conservative investor, you may look to preferred shares as means to collect large dividend payments. The relatively stable dividend payouts associated with preferred shares are largely due in part to corporate finance structure. Before buying into preferred shares, it is important for you to become familiar with how this asset class ranks within corporate finance, in comparison to stocks and bonds. Be advised that preferred shares are especially susceptible to inflation and interest rate risks.

Asset Claims

Preferred shares take their name from the fact that they feature senior asset claims above shares of common stock. This seniority means that preferred shareholders are to be paid prior to common shareholders from any asset liquidation sales that occur due to corporate bankruptcy. In terms of dividend payments, preferred shareholders must also receive dividends before any dividends are paid out on a corporation's common stock. Preferred share asset claims, however, are junior to bonds. The corporation is legally mandated to pay interest on bonds, but pays out preferred dividends at its discretion.

Risks Versus Rewards

Because of their senior asset claims that translate into a stable dividend, preferred shares are a more conservative investment than common shares. Preferred shares are often referred to as fixed income perpetuities, because they typically pay out a level dividend indefinitely. Similar to bond interest, the level dividend exposes you to both inflation and interest rate risks. Inflation describes a rising price level for goods and services that slashes the purchasing power of your future preferred dividends. Meanwhile, interest rate risks occur when interest rates rise, while you are effectively locked into preferred shares that would then generate relatively minimal investment income. At that point, you may be forced to sell off your preferred stock investment at a sharp price discount.

Voting Rights and Poison Pills

Contrary to shares of common stock, preferred shares do not carry voting rights. Because of these terms, convertible preferred shares are often part of poison pills designed to deter hostile takeovers. Because one share of common stock equals one vote, an outside investor can purchase more than 50 percent of a corporation's shares of common stock outstanding to control the entire company. From there, the acquirer can make an offer for all of the corporation's common shares and take the company back private. A poison pill, however, may make these transactions prohibitively expensive. With a poison pill, convertible preferred shareholders can exchange their preferred shares for large amounts of common shares -- after one investor acquires a set percentage of outstanding common stock.

Strategy

You can create a diversified portfolio of money market securities, preferred shares, and common stocks to manage risks and invest for growth. The money market securities and preferred shares will provide for liquidity and investment income, respectively, in most economic scenarios. Alternatively, stocks are ideal for long-term growth. As a measure for U.S. stock market performance, The S&P 500 Index has averaged 11 percent annual returns since its creation in 1957.

Preferred Shares Definition, Sources:

Investopedia: A Primer on Preferred Stocks

SEC: Convertible Securities

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