Like common stock, shares of preferred stock are equity securities -- that is, they represent partial ownership in a company. But preferred shares have much in common with bonds. In particular, the regular, fixed dividend payments received by preferred shareholders resemble the interest payments made on corporate bonds. And like bonds, preferred shares are sometimes redeemable, convertible or both.
Redeemable Preferred Shares
If a preferred share is redeemable, the company that issued it has the right to require the shareholder to sell the share back to the company. The rules for redemption -- such as the price the company must pay and the time frame in which it can require redemption -- will be detailed in the prospectus the company prepared when it first issued the stock. Redeemable shares are more commonly called "callable" shares.
Why Redeem Shares?
Unlike common stock, which pays a dividend only at the discretion of the company's board of directors, preferred shares pay their holders a guaranteed dividend. These dividends represent an ongoing financial obligation for the company, like the interest paid on bonds. But unlike bonds, preferred stock usually has no maturity date, so the obligation extends indefinitely. Making preferred stock redeemable gives the company a chance to get out from under the obligation by "calling" the shares. One scenario in which it might do this is if the preferred dividend exceeds what the company would pay on bonds under current interest rates. In that case, it could call in the shares, then issue new preferred shares with a lower dividend or bonds with lower interest payments. Bonds are frequently callable for this same reason: It lets the company refinance its capital at a lower cost.
Convertible Preferred Shares
A convertible preferred share is one that the holder can exchange for a specific number of shares of common stock; the exchange rate should be provided in the prospectus. Usually it's up to the preferred shareholder to decide whether to convert. In some cases, the company has the right to call in the shares and convert them rather than buy them back. Corporate bonds are also sometimes convertible.
Why Convert Shares?
Companies may prefer to convert preferred shares for the same reason they redeem them: to retire the shares and thus eliminate the dividend obligation. For shareholders, owning preferred stock rather than common is a tradeoff: Preferred dividends are guaranteed, whereas common stock dividends are not, but the fixed dividend essentially limits the price of the share. Meanwhile, the price of common stock is essentially unbounded -- if the company keeps growing and increasing its profits, the price can just keep rising. Converting preferred shares allows shareholders to take advantage of common stock's greater capacity for price growth.
- Investopedia: Introduction to Convertible Preferred Shares
- Investopedia: Callable Preferred Stock
- Financial Accounting for MBAs, Fourth Edition; Peter Easton, et al
- Thinkstock Images/Comstock/Getty Images