Preferred Stocks: How They Differ from Common Shares

Between Bondholders and Stockholders: An Uneasy Middle Ground

When Lehman Brothers filed for bankruptcy in September 2008, holders of the firm's common stock received nothing. Holders of its preferred stock received almost nothing. Holders of its senior bonds received cents on the dollar — still far more. This hierarchy — bonds first, preferred second, common last — is not arbitrary. It is embedded in corporate law and determines who survives a company's failure. Preferred stock occupies a specific niche in this capital structure, offering features of both debt and equity without being fully either.

Key Characteristics of Preferred Stock

Preferred stock is a class of equity that carries specified rights superior to those of common stock. Unlike common shares, preferred shares typically do not carry voting rights. The tradeoff is a fixed or floating dividend that must be paid before any dividends can flow to common shareholders.

• Dividend priority — preferred dividends must be paid before common dividends are declared
• Liquidation preference — in bankruptcy or dissolution, preferred holders are paid before common shareholders (but after all debt holders)
• Fixed dividend rate — most preferred stocks pay a stated dividend, often expressed as a dollar amount per share or as a percentage of par value
• No voting rights (typically) — preferred shareholders generally cannot vote on corporate matters
• Callable provisions — most preferred stocks can be redeemed (called) by the issuer at par value after a specified date

Types of Preferred Stock

Preferred Stock in the Capital Structure

When a company faces financial difficulty, the hierarchy of claims determines who gets paid. Senior secured debt holders are paid first from the proceeds of asset liquidation. Then come unsecured creditors. Subordinated debt follows. Preferred stockholders stand ahead of common equity holders but behind all debt categories. This seniority is weaker protection than holding bonds but stronger than holding common stock.

In practice, preferred dividends are not legally obligated in the same way bond interest is. Failing to pay interest on a bond triggers technical default. Failing to pay a preferred dividend does not — unless the preferred is cumulative, in which case the arrears must eventually be satisfied. This distinction makes preferred stock riskier than bonds but less risky than common equity from a credit perspective.

Who Issues Preferred Stock and Why

Financial institutions — banks, insurance companies, and utilities — are the largest issuers of preferred stock. Banks issue preferred shares to satisfy regulatory capital requirements under Basel III without diluting common equity as heavily as issuing new common stock. Preferred stock qualifies as Tier 1 capital for bank regulatory purposes.

Real estate investment trusts (REITs) and Master Limited Partnerships (MLPs) also issue preferred securities when they want to raise fixed-income capital without taking on traditional debt obligations that could stress their balance sheets.

Price Behavior and Interest Rate Sensitivity

Preferred stocks with fixed dividends behave similarly to long-duration bonds when interest rates change. Rising rates make fixed preferred dividends less attractive relative to new securities, pushing preferred prices down. Falling rates have the opposite effect.

• A preferred stock paying $2.00/year trading at $25 (par) yields 8%
• If market rates rise and comparable new preferreds yield 10%, this preferred must fall to $20 to offer the same yield
• Call risk adds complexity: if rates fall and the issuer calls the preferred at $25, the investor who paid $30 suffers a loss

The iShares Preferred and Income Securities ETF (PFF) tracks a broad index of U.S. preferred stocks and is widely used to access this asset class. Its effective duration is typically 4–6 years, significantly shorter than long-duration Treasury ETFs.

Tax Treatment of Preferred Dividends

Preferred dividends from domestic corporations are generally taxed as qualified dividends at the lower 0%, 15%, or 20% rates rather than ordinary income rates — provided the holding period requirement (90 days around the ex-dividend date) is met. This qualified status makes preferred stocks particularly attractive to investors in high tax brackets compared to bond interest, which is taxed as ordinary income.

However, dividends from REITs, MLPs, and foreign corporations are often classified as ordinary income rather than qualified dividends, reducing their after-tax yield advantage.

Preferred Stock in Practice: The Wells Fargo Example

Wells Fargo has issued multiple series of preferred stock throughout its history. During the 2008–2009 financial crisis, the U.S. government's Troubled Asset Relief Program (TARP) invested $25 billion in Wells Fargo in the form of senior preferred stock paying a 5% dividend, later rising to 9%. The government received this preferred treatment precisely because the senior preferred claim ensured repayment priority over existing common shareholders. Wells Fargo fully redeemed the TARP preferred by December 2009, paying the government approximately $1.4 billion in dividends during the repayment period.

Preferred Stock vs. Bonds vs. Common Stock

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