The Disadvantages of Preferred Shares

by Slav Fedorov

Preferred shares are a form of equity, as is common stock. Holders of preferred shares have priority over common stockholders in receiving dividends and filing property claims in bankruptcy liquidation. But preferred stock comes with several disadvantages compared with common stocks and some other types of securities.

Limited Upside Potential

Unlike common stocks that offer unlimited upside potential, preferred shares’ upside is limited by the additional features they carry. For example: Callable preferred stock can be called, or redeemed, by the issuer at par, or face value. Investors are reluctant to pay a premium over par if they know that the stock can be called from them at par.

Interest Rate Sensitivity

Investors typically buy preferred stocks for high current dividends. The dividends on most types of preferred stocks are fixed, which makes them similar to other types of fixed income securities such as bonds. Fixed dividends also make preferred shares sensitive to interest rate changes: When interest rates rise, prices of fixed income securities decline.

No Dividend Growth

Most preferred stock dividends are fixed and cannot increase over time, unlike common stock dividends. A preferred stock investor might initially be happy with the amount of dividend income, but inflation could erode its purchasing power over time.

Dividend Income Risk

Preferred stock dividends are not guaranteed. An issuer that experiences financial difficulties might reduce or suspend preferred dividends. Preferred shareholders would be stuck with shares that had neither appreciation potential nor dividends, and that nobody wanted.

Principal Risk

If an issuer files for bankruptcy, preferred shareholders have priority over common shareholders in filing property claims to recover their investment, but they are behind bondholders. Usually no assets are left when it is the turn of preferred shareholders to be paid. So preferred shareholders can suffer the same complete loss as common shareholders, despite their seniority.

Lack of Voting Rights

In most cases, preferred shares do not confer voting rights. That means their holders do not have a say in the important affairs of the corporation, such as a merger or amending the corporate charter. Nor can they participate in the election of the board of directors at annual shareholder meetings.

Worst of Both Worlds

Some investors believe that preferred stocks combine the worst features of stocks and bonds. That's because unlike common stocks, preferred stocks have limited upside potential, and their income and principal are less safe than those of bonds. An investor who is seeking capital appreciation is better off buying common stocks; if he is seeking safety of income and principal, he is better off buying bonds.

References (1)

  • “PassTrak Series 7: General Securities Representative License Exam”; Dearborn Financial Services; 2003