What it is…
Preferred stock, sometimes called preference stock, is a type of equity (ownership interest) in a company. Holders of preferred stock have at least one extra feature, sometimes called a “preference,” that holders of common stock don’t have. As a practical matter, however, unless the preferreds are convertible into common, US investors regard preferred stock as fixed income (debt), not equity. (This ignores the fact that preferreds are perpetual securities (they have no ending date), unlike virtually all fixed income, where the borrower is required to return the principal to the lender after a specified period of time.)
Typical “preferences”
The most frequent preference is liquidation preference, a place in line for recovery during a bankruptcy ahead of common shareholders. In my experience, equity holders of all stripes are wiped out in a bankruptcy, so this isn’t really an advantage at all.
Convertibility into another security, most often common share of the same company, is a second preference.
Many preferreds pay a higher dividend than common. The preferred dividend may be a fixed amount, say, $3/share per year; or it can be expressed as a percentage, say, 150% of the common dividend, with a fixed minimum payment.
Preferreds may also be cumulative, meaning that any unpaid dividends accumulate as obligations of the company. They must be paid in full before any common dividend may be paid.
Not all preferred features are good
Not all differences between preferred and common are plusses for preferred. Preferreds typically have no voting rights. Also, although in practice highly unlikely, it is still possible that the dividend on common could be increased to the point where it exceeds the amount paid to preferred.
Why have them at all?
Why issue preferreds?
–As you can see from the news, there may be obscure regulatory advantages to doing so in an industry like banking.
–Years ago (not now) corporate holders of preferreds paid almost no income tax on dividends they received, so preferred issues were very desirable.
–A company that’s losing money now and expects to do so for a while won’t have a tax reason to issue debt rather than preferred. If it finds buyers who want preferreds, this may be a cheaper financing option. (I’m really stretching here, but the have been instances of this happening. In fact, I’ve seen at least one issue of preferreds where the issuing company built in the right to convert the preferreds into debentures (when/if it returns to having taxable income)).
Preferred vs. two classes of common
An equity structure similar to having preferred and common is having two classes of common. An example is Hershey of the US, which has common stock and Class B common stock (the company has preferred, to boot, but I’m not concerned about that here). There are about 360 million common shares outstanding and 60 million Class B.
The main difference is voting rights. Class B shares, which are held by the Hershey Trust, get 10 votes per share;common shares get 1 per share. So the Hershey Trust controls the company, despite owning only about 15% of the outstanding stock. (Other differences: common is publicly traded and gets a 10% higher dividend than Class B, which is not publicly traded. Class B holders can convert into common on a one-for-one basis.)
Many family-owned companies choose this structure when they go public, in order to maintain control over the enterprise while raising large amounts of new capital. One might regard the Hershey Class B as convertible preferred shares whose advantage is a voting preference.
Outside the US
Like almost everything having to do with stocks, the rules change once you leave the US.
In continental Europe, for example, preferreds are most often considered as equity, not debt. For many mid-sized companies, preferreds may be the only shares traded on the public market (common retained by the founding family). Or they may be so much more liquid than the common that they are the only viable alternative for a non-family investor.
The polar opposite may be Korea, where preferreds have historically been regarded as markedly inferior securities and have performed in line with common only in the most speculative markets.
Asking a professional experienced in a given market is, I think, the surest way to get the local lay of the land. You should also give that person’s advice a sanity check by looking at performance of preferreds in a variety of different market conditions. You should be especially careful in situations where both common and preferred are publicly traded.