Preferred stock sits between bonds and common stock, with its own risks and rewards

Preferred stock is a share you can own in a company that pays you a fixed dividend — usually higher than what common stock pays — and gives you a claim on assets ahead of common shareholders if the company fails. But preferred stock does not give you voting rights the way common stock does, and the dividend is not may provide the way a bond payment is. The price moves with interest rates and company health, so you can lose money even while collecting dividends.

Preferred stock is not a bond, even though it feels like one. A bond is a loan with a maturity date; preferred stock has no end date unless the company calls it (buys it back). That means your money can be locked in for decades, and if interest rates rise, the price of your preferred shares will fall — sometimes sharply — because new preferred shares will offer higher dividends.

Key Takeaways

  • Preferred dividends are usually fixed but not legally may provide, so a company in trouble can cut or skip them without the same legal consequences as missing a bond payment.
  • Preferred stock prices fall when interest rates rise, because investors can buy newly issued preferred shares with higher dividends elsewhere.
  • You have no voting rights and no say in company decisions, unlike common shareholders.
  • If the company fails, preferred shareholders get paid after bondholders but before common shareholders, though in practice this protection is often worth little.
  • Preferred stock is usually bought through a brokerage account, and the dividend income is taxed as ordinary income unless the shares meet specific IRS rules.

How preferred dividends differ from bond payments

A bond coupon is a legal obligation. If a company misses a bond payment, it is in default and faces when ready legal action from bondholders. A preferred dividend is not a legal obligation in the same way. A company can cut or suspend preferred dividends if its board decides to, though doing so usually damages the stock price because investors see it as a sign of financial trouble.

This matters most during recessions or industry downturns. Banks, utilities, and insurance companies — which issue a lot of preferred stock — have cut preferred dividends during crises. Common shareholders lose voting power to stop it, and preferred shareholders have no legal recourse. You collect the dividend only if the company chooses to pay it.

The flip side: preferred dividends are usually paid before common dividends. If a company has limited cash, it will pay preferred shareholders before it pays common shareholders. But if the company is truly failing, both may go unpaid.

Interest rate risk and how it affects your price

When the Federal Reserve raises interest rates, newly issued preferred stock comes with higher dividend rates to attract buyers. Your existing preferred shares, which pay a lower fixed dividend, become less attractive. Their price falls so that the dividend yield (the annual dividend divided by the price) matches what new shares offer.

This is the opposite of what happens with common stock, which can rise or fall based on earnings and growth. With preferred stock, the math is mechanical: higher rates mean lower prices. If you need to sell before maturity, you may have to sell at a loss.

The longer the preferred stock has no call date (the date the company can buy it back), the more sensitive it is to rate changes. A preferred share with no call date can lose 20 to 30 percent of its value if rates rise 2 to 3 percentage points. A preferred share that can be called in five years is less sensitive because the company might call it if rates fall, capping your upside.

Call risk: when the company buys back your shares

Most preferred stock is callable, meaning the company can repurchase it at a set price (usually par value, or $25 per share) after a certain date. This protects the company but hurts you if rates fall. If you buy a preferred share paying 6 percent and rates drop so new preferred shares pay 4 percent, the company will call your shares and refinance at the lower rate. You get your $25 back but lose the higher dividend.

Call risk is real. During periods of falling rates, companies call preferred shares in large batches. You then have to reinvest the proceeds at lower rates. This is the opposite problem from interest rate risk: rates fall, and you lose the upside.

Check the call date and call price before you buy. A share callable in one year is much riskier than one callable in ten years. Some preferred shares are non-callable, but they usually pay lower dividends because the company has given up the option to refinance.

Credit risk: what happens if the company fails

Preferred shareholders rank ahead of common shareholders in bankruptcy but behind all bondholders. In theory, this means you get paid before common shareholders. In practice, by the time a company is bankrupt, there is often nothing left after bondholders are paid. Preferred shareholders frequently recover pennies on the dollar or nothing at all.

Credit risk varies by company. A utility with stable cash flow and investment-grade bonds is unlikely to fail. A bank or insurance company in a crisis is much riskier. Before buying, check the company's credit rating from Moody's, S&P, or Fitch. Preferred shares issued by companies rated below investment grade (below BBB- or Baa3) carry real default risk.

Some preferred shares are issued by financial institutions and are subject to regulatory capital rules. During a financial crisis, regulators can force a company to cut preferred dividends to preserve capital. This happened to bank preferred shares in 2008 and 2020.

Tax treatment of preferred dividends

Preferred dividends are taxed as ordinary income at your marginal tax rate, unless the shares meet specific IRS rules for may have access to dividends. Most preferred stock does not may have access to. This means if you are in the 24 percent tax bracket, a 6 percent dividend is really a 4.56 percent dividend after tax.

Some preferred shares issued by corporations may may have access to for the corporate dividend-received deduction if you own them in a taxable account, but this applies mainly to corporate investors, not individuals. Check with your tax preparer or the company's prospectus to confirm the tax treatment of any preferred share you are considering.

In a retirement account (401(k), IRA, or similar), preferred dividends are not taxed as you collect them, so the tax treatment does not matter. This makes preferred stock more attractive in retirement accounts than in taxable accounts.

How to compare preferred shares to bonds and common stock

Preferred stock is a middle ground, but that does not mean it is the right choice for your situation. Compare the yield (annual dividend divided by price) to what you could earn in a bond with similar maturity and credit quality. If a preferred share pays 5 percent and a bond from the same company pays 4 percent, the extra 1 percent is compensation for the risks you are taking: no maturity date, no legal may provide of payment, and call risk.

Compare the yield to common stock dividend yield as well. Common stock can grow in price and increase its dividend over time; preferred stock usually cannot. If common stock from the same company pays 2 percent and has room to grow, it may offer better long-term returns than preferred stock paying 5 percent, though with more volatility.

Consider your time horizon. If you need the money in five years, preferred stock is risky because rates may have risen and the price may be down. If you can hold for ten years or more and do not need the money, preferred stock may fit as an income-producing part of a diversified portfolio.

Frequently Asked Questions

Can I lose money on preferred stock if the dividend is paid?

Yes. The dividend and the price are separate. You can collect a 6 percent dividend and still lose 15 percent on the price if interest rates rise. Your total return is the dividend plus or minus the price change. If you sell after rates have risen, you may sell at a loss that outweighs the dividends you collected.

What does it mean when preferred stock is called?

The company buys back your shares at the call price (usually $25) on or after the call date. You get your money back but lose the dividend stream. This usually happens when interest rates fall and the company wants to refinance at a lower rate. You then have to reinvest the proceeds, likely at lower rates.

Is preferred stock safer than common stock?

Preferred stock is safer in a bankruptcy because you rank ahead of common shareholders. But it is not safer in terms of price volatility. Preferred prices fall when interest rates rise, sometimes by 20 to 30 percent. Common stock can also fall, but it can also grow in price and dividends over time. Neither is universally safer.

Should I buy preferred stock in a taxable account or a retirement account?

Preferred stock is usually better in a retirement account because the dividends are taxed as ordinary income, and you avoid that tax inside an IRA or 401(k). In a taxable account, the tax drag reduces your after-tax return. If you have limited retirement account space, bonds or dividend-paying stocks that may have access to for lower tax rates may be better choices for taxable accounts.

What is the difference between preferred stock and a bond ladder?

A bond ladder is a series of bonds with different maturity dates, so you get your principal back on a schedule and can reinvest at current rates. Preferred stock has no maturity date and no schedule. You collect dividends indefinitely unless the company calls the shares or cuts the dividend. Bonds offer more certainty about when you get your money back; preferred stock does not.