Preferred stock sits between bonds and common stock, and that middle ground shapes every decision you make about it
Preferred stock pays you a fixed dividend — usually 5% to 8% annually — before common shareholders get anything. If the company fails, preferred shareholders get paid before common shareholders but after bondholders. That sounds safer than common stock, but preferred stock is not a bond, and the safety comes with real trade-offs you need to understand before you buy.
The core trade-off is this: you get a higher, more reliable income stream than common stock offers, but you give up the chance to profit if the company's stock price soars. You also take on credit risk — if the company struggles, your dividend can be cut or suspended, and your shares can lose value fast. The fixed income sounds like a bond, but preferred stock has no maturity date and no legal obligation to pay you anything if the board decides to suspend the dividend.
Key Takeaways
- Preferred stock pays a fixed dividend before common shareholders are paid, but that dividend can be suspended if the company's board votes to do so.
- If the company goes bankrupt, preferred shareholders are paid after bondholders but before common shareholders, which is safer than common stock but riskier than debt.
- Preferred stock does not appreciate the way common stock does, so you are buying income, not growth — your return is almost entirely the dividend.
- Interest rate risk affects preferred stock prices: when interest rates rise, preferred stock prices fall because new preferred issues pay higher dividends and become more attractive.
- Call risk means the company can buy back your shares at a set price if rates fall, capping your upside while you keep the downside risk.
How preferred dividends work and what can go wrong
A preferred stock typically pays a dividend expressed as a percentage of its par value — usually $25 per share. A 6% preferred stock on a $25 par value pays you $1.50 per share per year, usually in quarterly installments of $0.375. That payment comes before common shareholders see a dime, which is why it feels safer.
But "comes before" does not mean "may provide." The company's board can suspend the dividend if cash runs short. When that happens, you do not lose your shares, but you stop receiving income. Suspended dividends sometimes accumulate (in "cumulative" preferred stock), meaning the company owes you back payments if it resumes dividends later. Other preferred stock is "non-cumulative," meaning suspended dividends are simply gone. Read the prospectus to know which type you own.
Dividend cuts are rare for large, stable companies but common for banks, utilities, and financial firms during downturns. If you own preferred stock in a company that cuts its dividend, your share price typically falls 10% to 20% immediately because the income you bought it for has shrunk.
Interest rate risk: why rising rates hurt preferred stock prices
Preferred stock prices move inversely with interest rates. When the Federal Reserve raises rates, new preferred stock issues pay higher dividends to attract buyers. Your existing preferred stock, which pays a lower rate, becomes less attractive. To sell it, you have to accept a lower price.
The longer the maturity (or the longer until the company can call the stock), the bigger the price drop. A preferred stock with no call date and a 5% dividend might fall 15% to 20% if rates rise 2 percentage points. That loss is real money if you need to sell before rates fall again.
This is the opposite of what happens with common stock. Common stock can gain value when rates rise if the company benefits from higher rates (like banks do). Preferred stock almost always loses value when rates rise, because you are holding a fixed-income security in a rising-rate environment.
Call risk: the company's option to buy you out
Most preferred stock is "callable," meaning the company can buy back your shares at a set price (the call price, usually $25) after a certain date. Call risk is the risk that the company exercises that option when it benefits them, not you.
Here is how it hurts: suppose you buy a 6% preferred stock at $20 per share because rates are high and you want the income. Rates fall, and the stock price rises to $26. The company can now call the stock at $25, forcing you to sell at that price. You miss the upside, but you keep the downside risk if rates rise again and the stock falls to $18.
Call risk is highest when rates are falling and preferred stock prices are rising. The company refinances by issuing new preferred stock at a lower rate and calling the old stock. You get your principal back but lose the higher income stream and have to reinvest at lower rates.
Credit risk: what happens if the company struggles
Preferred stock is only as safe as the company that issues it. If the company's credit rating falls, preferred stock prices fall faster than the company's common stock sometimes does, because preferred shareholders are counting on that fixed income and have less upside to compensate for the risk.
In bankruptcy, preferred shareholders are paid after bondholders but before common shareholders. That sounds good until you realize that in most bankruptcies, there is not much left after bondholders are paid. Preferred shareholders often recover 20 to 50 cents on the dollar, or nothing at all.
This is why preferred stock from a stable utility or large bank is safer than preferred stock from a smaller financial company or a company in a cyclical industry. The company's industry and financial health matter as much as the dividend rate.
Comparing preferred stock to bonds and common stock
Preferred stock is not a replacement for either bonds or common stock — it is a different risk-return profile that makes sense in specific situations.
| Feature | Preferred Stock | Bond | Common Stock |
|---|---|---|---|
| Income | Fixed dividend, can be suspended | Fixed interest, legally required | Variable dividend, often none |
| Bankruptcy priority | After bonds, before common | Before preferred and common | Last |
| Price appreciation | Limited; moves with rates | Limited; moves with rates | Unlimited potential |
| Interest rate risk | High; prices fall when rates rise | High; prices fall when rates rise | Low; can benefit from higher rates |
| Maturity | No maturity; can be called | Fixed maturity date | No maturity |
Bonds are safer because the company is legally required to pay interest and return your principal at maturity. Preferred stock has no maturity and no legal obligation to pay. Common stock offers growth potential but no may provide income. Preferred stock offers income without growth, making it useful for investors who want higher yield than bonds but do not need the legal protections bonds provide.
When preferred stock makes sense in a portfolio
Preferred stock works best when you are looking for income and can tolerate price swings tied to interest rates. It makes sense if you own a diversified portfolio and want to increase yield without taking on the volatility of common stock.
Preferred stock is less useful if you need your money in the next few years, because rising rates could force you to sell at a loss. It is also less useful if you are in a high tax bracket, because preferred dividends are taxed as ordinary income (not at the lower capital gains rate), making the after-tax yield lower than it appears.
Preferred stock from a single company concentrates risk. Most investors who buy preferred stock do so through a preferred stock fund or ETF, which owns dozens of issues and spreads the credit risk. That approach also handles the complexity of tracking different call dates, cumulative versus non-cumulative terms, and rate resets.
Frequently Asked Questions
Is preferred stock safer than common stock?
Preferred stock is safer in bankruptcy — you get paid before common shareholders — but it is not safe in the way a bond is. The dividend can be suspended, the price can fall when rates rise, and the company can call your shares away. It is safer than common stock but riskier than a bond from the same company.
What does "callable" mean and why does it matter?
Callable means the company can buy back your shares at a set price after a certain date. It matters because the company will call the stock when rates fall and your shares are worth more than the call price, capping your upside. You keep the downside risk if rates rise again.
Do I pay taxes on preferred dividends the same way as common stock dividends?
Preferred dividends are taxed as ordinary income, not at the lower capital gains rate that applies to may have access to common stock dividends. That makes the after-tax yield lower than the stated dividend rate, especially if you are in a high tax bracket. Check with a tax professional about your specific situation.
What happens to preferred stock if interest rates fall?
Preferred stock prices rise when rates fall, because the fixed dividend becomes more attractive relative to new issues paying lower rates. But the company can call the stock, forcing you to sell at the call price and reinvest at lower rates. You gain some upside but lose the ability to keep the higher income long-term.
Should I buy preferred stock from a single company or a fund?
A fund or ETF is simpler and spreads credit risk across dozens of companies. A single preferred stock gives you more control but concentrates risk in one company and requires you to track call dates and dividend terms. Most individual investors benefit from a fund approach.