In an attempt to combine the most attractive features of bonds and common stock, financial experts created "preferred stock." In most cases, it pays more than a bond, but is safer than common stock because of its "preferred" position.
Preferred stock generally involves far fewer shares than the common, and far less money than is represented by bonds. The majority of companies do not even have a preferred issue, although some, particularly utilities, may have several.
Where it exists, preferred stock is entitled to its dividend after bond interest has been paid and before a dollar goes to the common. Many preferreds pay $6, $7, and even $8 a share; when issued at a $100 par value this would mean a 6, 7, or 8 percent return. Today most of them are priced to yield closer to 5 percent.
Dividends, furthermore, are in most cases cumulative, which means that if the company skips one or more, it must pay off everything in arrears before a common dividend can be declared.
Some preferreds are "participating," which permits them, in the event an extra large melon is cut, to receive additional dividends. The formulas vary; sometimes it is share-and-share-alike with the common, sometimes there is a limit on the extras the preferred can receive.
Preferreds may also be convertible into common stock of the company at a stipulated ratio. Because this is an attractive feature for investors, it often means that the issue may carry a lower dividend rate than would otherwise be expected. If you should buy a convertible preferred, however, see whether it is protected against dilution of the common. Assume, for instance, that the common is selling at $90 and the conversion rate is two common shares for each preferred. Now the common splits, 3 to 1. Each share is now $30. And each preferred share, instead of being worth $180, is worth only $60 when converted. Stock dividends, rights, and mergers may also alter the conversion ratio. A convertible should provide that the holder will get not only a certain number of shares, but equivalent value as well.
Note, too, whether your preferred is callable and, before you buy, whether it is selling above the call price. This is a price, pegged by the company at the time the stock was issued, at which shares may be retired, regardless of the market price. Obviously, therefore, there is some risk in buying at 110 a preferred callable at 105, unless it is pretty clear the company has no intention of retiring the stock. Fortunately, company intentions are fairly predictable, for preferreds, being a fixed-interest item, are also tied to money rates. The risk to a callable preferred, therefore, is a period of cheap money. You may be sure that a company able to borrow money at 2.5 percent will not hesitate to redeem as many shares of its 5 percent callable preferreds as possible.
Preferred stock might not be a big money-maker, but its returns are generally better than bonds. If a young couple invests in preferred stock in a solid company early in their careers, it is possible they could build up a healthy cushion by the time they are ready to retire.