Preferred Stock Risk & Investor Profile

Benefits

The benefits of preferred stock mainly come from the dividends it pays. Depending on the investor and the security’s features, preferred stock may also offer tax advantages, higher return potential, and (in some cases) capital appreciation.

Cash dividends

• The primary benefit of preferred stock is its fixed dividend rate, which provides income. Preferred stock typically pays dividends on a periodic basis.

For example:

An investor purchases 10,000 shares of a 5%, $100 par preferred stock

If the Board of Directors (BOD) approves the dividend, the investor will receive $50,000 per year:

5% × $100 par × 10,000 shares = $50,000

• This income feature is especially important for investors who want steady cash flow, such as retirees replacing employment income.
• ⚠️ Dividend payments aren’t guaranteed, but that added uncertainty is one reason preferred stock often offers higher income rates than debt securities.
• In general, taking on more risk can lead to higher expected returns. For an income-focused investor who’s willing to accept some risk in exchange for higher income, preferred stock can be a suitable choice.

Lower tax rates

• Dividends from stock (common and preferred) are generally taxed at lower rates than interest from many fixed-income securities.

🔑 Tax comparison:

• That difference makes dividend income relatively tax-advantaged, especially for investors in higher tax brackets.

Corporate dividend exclusion rule

• Corporate investors* may receive even greater tax benefits through the corporate dividend exclusion rule, which allows corporations to exclude a portion of dividends received from taxation. This rule applies to dividends from both preferred and common stock.
• ⚠️ *This rule only applies to corporations structured as C-corps and does not apply to S-corps or any other business form. Various business structures are discussed later in the material.

🔑 In particular, corporations can avoid paying taxes on:

• Corporations often invest through brokerage accounts for the benefit of the business, which can result in owning shares of other companies.

For example, assume General Electric (GE) owns a small portion of Coca-Cola (KO) stock. If Coca-Cola pays a dividend of $100,000 to GE, GE will only pay taxes on $50,000 (a 50% exclusion). If GE owned 20% or more of Coca-Cola, it would only pay taxes on $35,000 of the $100,000 dividend (a 65% exclusion).

“Preferred” status

• Another dividend-related benefit is the “preferred” status preferred stock has relative to common stock:
  • If a company pays a dividend to common stockholders, it must pay preferred stockholders first.
  • If the preferred shares are cumulative, the issuer must also pay any previously skipped preferred dividends before paying a common stock dividend.
• Preferred stock also has priority over common stock in liquidation.
• ⚠️ Preferred stockholders are still behind unpaid wages, unpaid taxes, and bondholders, but they receive liquidation proceeds before common stockholders.

Added features

Some benefits of preferred stock come from special features. In particular, participating and convertible preferred stock can increase an investor’s return potential.

Capital gains without added features

• Capital gains are possible with preferred stock, but they’re generally less likely than with common stock.
• ⚠️ Preferred stock prices are usually influenced more by interest rate movements than by the company’s operating success.
• If the shares are not participating or convertible, the dividend rate is fixed and doesn’t change, even if the company performs very well.
• 🔑 In most cases, preferred stock prices rise mainly when interest rates fall. Since interest rate movements are difficult to predict, investors typically don’t buy preferred stock expecting capital gains.

Risks

Preferred stock is often grouped with income-oriented investments, but it still carries meaningful risks. ⚠️ Understand these risks before treating preferred stock as a “safe” alternative to common stock.

Skipped dividends

• Dividend payments require approval from the Board of Directors (BOD). If the company is under financial stress, it may skip or suspend dividends.
• ⚠️ Unlike bond interest, dividends are not a legal obligation of the issuer. Skipping dividends can damage the issuer’s reputation and make future fundraising harder, but preferred stockholders generally have no legal recourse if dividends aren’t paid.
• If the preferred stock is straight (non-cumulative), any skipped dividends are never made up.

Bankruptcy

• If a company’s financial condition deteriorates further, it may file for bankruptcy. If the company can’t reach an agreement in bankruptcy court, creditors may force liquidation.
• Liquidation means the company stops operating, sells its assets, and uses the proceeds to repay creditors and investors based on priority.
• Preferred stock has higher priority than common stock, but it ranks below most other claims.

Corporate liquidation priority

• ⚠️ By the time wages, taxes, and creditor claims are paid, there’s often little (or nothing) left for stockholders, including preferred stockholders. This risk is especially important when investing in financially weak issuers.

Interest rate risk

• Even if the issuer remains financially stable and continues paying dividends, preferred stock is still exposed to interest rate risk.
• 🔑 When interest rates rise, preferred stock prices tend to fall. (This relationship was covered earlier in the unit.)
• If an investor sells preferred stock after interest rates rise, the sale may result in a capital loss (selling for less than the purchase price).

Inflation (purchasing power) risk

• Inflation (purchasing power) risk occurs when prices across the economy rise more than expected. Fixed-income-style investments are especially exposed because their cash flows are generally fixed.

Using the earlier example:

An investor purchases 10,000 shares of a 5%, $100 par preferred stock

The investor receives $50,000 per year in dividends:

5% × $100 par × 10,000 shares = $50,000

• That $50,000 may provide substantial income today. But if inflation rises significantly, the same $50,000 buys less over time.
• As the dollar loses purchasing power, the fixed dividend becomes less valuable in real terms. ⚠️ This is one reason higher inflation tends to push preferred stock prices down.

Call features — call risk and reinvestment risk

• Callable preferred stock adds another risk: call risk. Call risk typically shows up when interest rates fall, because issuers may call (redeem) higher-rate securities and refinance at lower rates.

An investor owns 10,000 shares of a 5%, $100 par callable preferred stock. Interest rates fall to 3% and the issuer calls the shares at par. The investor reinvests the proceeds back into another set of preferred stock with a comparable risk profile and buys 10,000 shares of a 3%, $100 par preferred stock.

In this example, the investor’s annual dividend income drops:

• Before the call: 5% × $100 × 10,000 = $50,000
• After reinvesting: 3% × $100 × 10,000 = $30,000

• 🔑 This is a classic case of call risk, which is often described as the worst form of reinvestment risk.
• Reinvestment risk occurs when proceeds from an investment (typically dividends or interest) must be reinvested at lower rates of return. Many investors reinvest dividends or bond interest to keep funds fully invested. When interest rates fall, new fixed-income investments generally offer lower yields.
• ⚠️ Even if a preferred stock isn’t called, reinvestment risk can still apply to dividends that are reinvested at lower prevailing rates.

Typical investor

• Preferred stock is generally suitable for investors who want income.
• ⚠️ If an investor’s primary goal is capital appreciation (capital gains), common stock is usually a better fit. Convertible preferred stock can offer capital appreciation potential, but the conversion feature is typically an added benefit rather than the main reason to buy the security.
• Income-focused investors are often risk averse (they prefer to avoid risk). Under the rule of 100, investors generally allocate more to fixed income as they get older. For that reason, preferred stock investors are often older and more conservative.
• At the same time, preferred stock dividends can be skipped or suspended by the Board of Directors (BOD). Because dividend payments aren’t guaranteed, preferred stock is typically considered a moderate risk investment.

🔑 Risk placement:

• ⚠️ Therefore, the most conservative investors often avoid preferred stock and instead choose safer fixed-income securities such as US Government debt. For these investors, the possibility of suspended dividends and market price fluctuations may be too much risk.
• For a moderate or fairly conservative investor who’s willing to accept somewhat higher risk in exchange for higher income, preferred stock can be a suitable choice.

Time horizon

• Preferred stock generally has no maturity or expiration date, so investors should expect to hold it for long periods. While shares can be callable or sold in the secondary market, many preferred stock investments are held for years.
• Because income is the primary benefit, it often takes time to collect substantial dividends (most preferred shares pay quarterly).
• Also, interest rates can rise, which can push preferred stock prices down. Investors with short time horizons may be forced to sell at a low price if rates rise sharply.
• Longer time horizons allow investors to collect dividends over time and better tolerate price fluctuations caused by interest rate changes.

Corporate investors

• Corporations are also major investors in preferred stock. As discussed earlier, corporations may qualify for at least a 50% exclusion on dividends received from stock investments.
• If a corporation has funds available and is seeking income, preferred stock can offer a tax-advantaged opportunity.

Key points

Benefits of preferred stock

• Fixed dividend rate provides income
• Lower tax rates (15% or 20%)
• Higher income rates than debt securities

Corporate dividend exclusion rule

• Corporations avoid paying taxes on dividends
• 50% exemption if owning less than 20% issuer’s common stock
• 65% exemption if owning 20% or more of the issuer’s common stock

Participating preferred stock

• Eligible to receive more than the stated dividend rate
• Issuers pay more in profitable years

Convertible preferred stock

• Convertible into common stock of the same issuer
• Has capital appreciation potential

Preferred stock risks

• Dividends are not guaranteed
• No legal recourse for skipped dividends
• Subject to:
  • Interest rate risk
  • Inflation (purchasing power) risk
  • Call risk
  • Reinvestment risk

Preferred stock typical investors

• Must seek income as the primary benefit
• Accepts moderate risk in return for higher income
• Long-term time horizons
• Corporate investors (due to tax benefits)

Sources

Primary/official references for the material in this chapter. Every link was fetched and returned HTTP 200 on 2026-08-15.