Preferred stock is equity on a company's balance sheet but behaves in the market much like a bond. Its terms combine a fixed payment obligation with the subordination of an ownership claim.
Priority defines the position
Preferred shareholders rank ahead of common shareholders for dividends and for any distribution in liquidation. They rank behind every creditor, including bondholders and general trade claims.
That middle position is the defining feature. It provides more certainty than common equity and less protection than lending to the same company.
Priority applies to the claim, not to a guarantee. A company with insufficient assets satisfies senior claims first, and preferred holders may recover little.
Dividends are stated but not legally required
A preferred issue specifies a dividend rate applied to a par value. Unlike interest on debt, the payment is declared by the board rather than owed contractually.
Skipping a preferred dividend does not constitute default in the way missing a bond coupon does. It does typically block any dividend on common shares until the preferred position is addressed.
Cumulative issues require missed payments to be made up before common dividends resume; non-cumulative issues do not, which makes the distinction material.
Price responds to interest rates rather than earnings
Because the payment is fixed, the market value of a preferred share moves inversely with prevailing yields, in the same manner as a long-dated bond.
Growth in company earnings does not raise the payment, so preferred prices generally do not participate in a rising common share price. The upside is capped by the fixed distribution.
Perpetual issues with no maturity date are especially sensitive to rate movement, since there is no redemption date pulling the price toward par.
Call features and conversion sit in the terms
Most issues are callable after a stated date, allowing the company to redeem at a set price. Issuers exercise that right when they can refinance more cheaply, which limits how far a price rises.
Convertible preferred can be exchanged for a specified number of common shares, adding participation in equity appreciation at the cost of a lower stated rate.
Reading the prospectus for call dates, cumulative status and conversion terms is what distinguishes one issue from another with an identical stated rate.
Issuers and holders use it for different reasons
Banks and utilities are frequent issuers because preferred capital can satisfy regulatory capital definitions or support credit ratings without diluting voting control.
Corporate holders in the United States may receive different treatment on dividends received from another corporation than individuals do, which affects who the natural buyers are.
The instrument exists precisely because that intermediate rung, between lending and owning, is useful to both sides of the transaction.