Definition of preferred stock
preferred stock (plural preferred stocks)
- (finance) Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock and that has priority to common stock in liquidation.
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument. Preferreds are senior (i.e., higher ranking) to common stock, but are subordinate to bonds.
Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Preferred stock may have a convertibility feature into common stock. Terms of the preferred stock are stated in a "Certificate of Designation".
Similar to bonds, preferred stocks are rated by the major credit rating companies. The rating for preferreds is generally lower since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.
Preferred stock is a special class of shares that may have any combination of features not possessed by common stock.
The following features are usually associated with preferred stock:
- Preference in dividends.
- Preference in assets in the event of liquidation.
- Convertible into common stock.
- Callable at the option of the corporation.
In general, preferreds have preference to dividends payments. A preference does not assure the payment of dividends, but the company must pay the stated dividend rate prior to paying any dividends on common stock.
Preferred stock can either be cumulative or noncumulative. A cumulative preferred requires that if a company fails to pay any dividend or any amount below the stated rate, it must make up for it at a later time. Dividends accumulate with each passed dividend period, which can be quarterly, semi-annually, or annually. When a dividend is not paid in time, it has "passed" and all passed dividends on a cumulative stock is a dividend in arrears. A stock that doesn't have this feature is known as a noncumulative or straight preferred stock and any dividends passed are lost forever if not declared.
Preferred stocks offer a company an attractive alternative form of financing. In most cases, a company can defer dividends by going into arrears without much of a penalty or risk to their credit rating. With traditional debt, payments are required and a missed payment would put the company in default.
Occasionally companies use preferred shares as means of preventing hostile takeovers, creating preferred shares with a poison pill or forced exchange or conversion features that exercise upon a change in control. Some corporations contain provisions in their charters authorizing the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These "blank checks" are often used as takeover defense (see also poison pill). These shares may be assigned very high liquidation value that must be redeemed in the event of a change of control or may have enormous supervoting powers.
When a corporation goes bankrupt, there might be enough money to repay holders of those preferred issues that are known as "senior", but not enough money for "junior" issues. So when the preferred shares are first issued, sometimes their prospectuses (contracts) contain protective provisions which prevent the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior, pari passu (equal) or junior relationship with other series issued by the same corporation.
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