How Preferred Stock Works: Income, Priority, and Hybrid Risks

Warren Buffett Has Made Billions From Preferred Stock — Most Retail Investors Barely Know It Exists

During the 2008 financial crisis, Warren Buffett's Berkshire Hathaway invested $5 billion in Goldman Sachs preferred stock at a 10% annual dividend — a guaranteed $500 million per year regardless of market conditions. During the COVID-19 crisis in 2020, Berkshire invested $10 billion in Occidental Petroleum preferred stock at 8%. These are not exotic transactions available only to billionaires — they are sophisticated uses of a security class that any investor can access. Understanding preferred stock turns an obscure corner of the capital markets into a potentially useful income tool.

Where Preferred Stock Sits in the Capital Structure

Every corporation has a hierarchy of claims on its assets and income — the capital structure. Preferred stock occupies a specific position in this hierarchy.

Claim Priority	Security Type	In Bankruptcy	During Normal Operations
Highest	Senior secured debt	Paid first from secured assets	Interest paid before anything else
Second	Senior unsecured debt	Paid after secured creditors	Interest required before dividends
Third	Subordinated debt	After senior creditors	Interest required before dividends
Fourth	Preferred stock	After all debt; before common	Dividends required before common dividends
Lowest	Common stock	Last; often receives nothing in bankruptcy	Dividends at board discretion

Preferred stockholders do not have a contractual obligation the company must meet — unlike bond interest, preferred dividends can be suspended. However, most preferred issues include provisions that restrict common dividends if preferred dividends are in arrears, creating strong incentives for issuers to maintain preferred payments.

Types of Preferred Stock

Cumulative vs. Non-Cumulative

Cumulative preferred stock accumulates any missed dividends — called dividends in arrears. The company cannot pay common stockholders until all accumulated preferred dividends are paid. Most exchange-listed preferred shares are cumulative. Non-cumulative preferred (common in bank-issued securities) allows the company to permanently skip dividends without obligation to catch up — a meaningfully worse protection for investors.

Callable Preferred

Most preferred stock is callable — the issuer can redeem it at a specified call price (typically par value, usually $25) after a specified date (typically five years from issuance). This creates the call risk that investors face in fixed-income securities generally: if rates fall after issuance, the company will call the preferred and reissue at a lower yield, removing your high-income security precisely when reinvestment opportunities are least attractive.

Convertible Preferred

Convertible preferred shares include an option to convert to common stock at a predetermined ratio. This gives investors bond-like downside protection (dividend priority) plus equity-like upside participation if the stock price rises above the conversion price. Convertible preferred is the standard equity structure for venture capital and private equity investments, offering investors downside protection alongside potential equity upside.

Participating Preferred

In addition to fixed dividends, participating preferred shares entitle holders to additional dividends if common stock dividends exceed a certain threshold. This structure is common in private company preferred rounds but rare in public markets.

How Preferred Dividends Are Taxed

Most preferred dividends from corporations are classified as qualified dividends — taxed at the long-term capital gains rate (0%, 15%, or 20% depending on income bracket) rather than ordinary income rates. This is a meaningful advantage over bond interest, which is taxed as ordinary income. However, preferred dividends from REITs and certain other structures may be classified as ordinary income — check the 1099-DIV carefully.

Preferred Stock vs. Bonds: Key Differences

Feature	Investment-Grade Corporate Bond	Preferred Stock
Payment obligation	Contractual; must pay or default	Discretionary; can be suspended
Bankruptcy claim	Senior to preferred	Junior to all debt; senior to common
Dividend/interest taxation	Ordinary income	Often qualified dividend rate
Call risk	Present for callable bonds	Very common; typically callable at $25
Maturity	Defined maturity date	Usually perpetual (no maturity)
Interest rate sensitivity	High (duration-based)	Very high (perpetual; no maturity anchor)

Risks Specific to Preferred Stock

Duration risk: Perpetual preferred shares have effectively infinite duration — they are among the most interest rate sensitive securities available. A 1% rise in rates can reduce perpetual preferred prices by 10–15%.
Credit risk: Unlike bonds, preferred dividends are not legally required. Financial stress can cause suspension, and in bankruptcy, preferred holders often receive nothing or pennies on the dollar.
Call risk: The issuer calls your high-yielding preferred just when you want to keep it.
Illiquidity: Many individual preferred issues trade in thin markets with wide bid-ask spreads.

Where to Find Preferred Stock

Individual preferred shares trade on major exchanges (NYSE and Nasdaq) under ticker symbols typically consisting of the common stock ticker plus a suffix (e.g., BAC-PL for Bank of America Series L preferred). Preferred ETFs provide diversified access: iShares Preferred and Income Securities ETF (PFF) is the largest with approximately $14 billion in assets and a yield historically around 5–7%. Invesco Preferred ETF (PGX) and PGIM Preferred Securities ETF (PFFD) are alternative options with varying sector exposures and yields.

Banks and utilities are the largest issuers of exchange-listed preferred stock. Financial sector preferred exposure means portfolio performance during banking sector stress events is a key risk to understand before investing.

This article is for informational purposes only and does not constitute financial advice.