Preferred stocks are one of those securities that can create some confusion in those that are learning about investing. The thing about preferred stocks is that the have qualities of both bonds and stocks. Basically, if you own this type of security you would have some benefits of both an owner and a lender.

In this article I will be discussing some of the basics about this type of security so that you can some general knowledge about how they work along with the risk associated with them.

Preferred stocks are sort of like a hybrid between a bond and a stock. They are usually considered fixed income assets like bonds although the yield can sometimes be variable to some extent like for example preferred shares that use the LIBOR index to calculate payments.

Dividends are paid only if the company actually declares a dividend and if they do, owners of preferred shares have priority over owners of common stock. In other words, if a company declares a dividend, owners of common stock get paid after owners of preferred stock. Some companies declare small dividends to pay only owners of preferred stock and don’t pay a dividend to owners of common shares like some banks did during the financial crisis.

Owners of this type of security get special treatment in case the company goes belly up. For example, if a company files for bankruptcy and is forced to liquidate the first people and institutions that are paid if there is actually a way to get some of the money back are lenders and bond holders followed by owners of preferred shares and finally the owners of common stock. As you may have guessed, owners of common shares usually get pennies on the dollar if a company fails badly. People that have preferred shares have more of a chance to get some of the principle back.

A bond has what is called face value or the amount that the owner will receive at the time of maturity, analogous to a bond’s face value is a preferred share’s par value. The par value of a share is the amount that the company will pay for the share if it callsit. When a company calls their preferred share they basically stop paying dividends to their owners and buy back the share, usually at par value returning that amount to the shareholder. The security usually has a specific date when it becomes callable.

Remember that just because a share becomes callable doesn’t mean that the company will do so but it can happen at any time. Another thing is that the investor needs to watch out for the price of the share as the call date nears and be careful not to overpay for a security that can be called soon.

Some Examples of Possible Outcomes Of Preferred Stock Investments:

Example 1, company “A “calls its preferred stock at par value ($25). John has 10 preferred shares which he bought at $25 dollars each so he receives $250 in exchange for his shares. John made money because he held the securities for some years and received cash dividends throughout the time he held the securities.

Example 2, Peter bought 10 preferred shares yielding 6% of company “B” which have a par value or $30 for $33 dollars each. He held those shares for 10 years and they were called by company “B”. Peter still got a decent return since the amount of dividends that he received during the time where more than enough to offset the capital loss of $3 per share (10 x $3 lost per share = $30 capital loss vs. $300 x .06 interest x 10 years = $180 – Capital loss of $30 = $150 in profits in addition to the $300 he received from the company for his shares).

Example 3, James bought 10 preferred shares of company “C” out of hype and didn’t check the call date. The shares went callable two months after James bought them and the company decided to call them. James paid $40 dollars for each. And they had a par value of $35. Since the company called the shares before declaring a dividend James lost money ($40 x 10 - $35 x 10 = $50 capital loss) when the company only gave him $35 for each share.

These are simple examples to help you get a general idea on some of the possible scenarios that an investor can face and the difference between a good investing decision and a poor one. Preferred shares are also subject to interest risks. In other words if interest rates go up the price of preferred shares go down.

These types of securities have terms and rights that you should examine before investing in them. To do this you need to download the necessary information from the company’s website in order to know more about what you are buying. Some securities can be convertible or may even have voting rights (something that preferred shares normally don’t have). Study what you are buying before parting with your cash especially if you are investing for the long term. One thing for sure is that they a great addition to any diversified portfolio especially if the portfolio focuses on dividend stocks and other high income assets.