Common vs. Preferred Stock Structures and Rights

Common stock and preferred stock represent fundamentally different ownership claims on a company. Common shareholders own residual equity (what remains after all other claims are paid), while preferred shareholders own priority claims on dividends and liquidation proceeds. In the US public markets, common stock dominates trading volume, but preferred stock represents $500+ billion in market value across financial institutions, utilities, and REITs (S&P Dow Jones Indices, 2024). Understanding these structures matters because preferred shares behave more like bonds than stocks during market stress.

Defining Common and Preferred Stock

Common Stock

Common stock represents the base ownership layer of a corporation. Common shareholders have the weakest claim on assets but unlimited upside participation.

Core rights of common shareholders:

• Voting rights: Typically one vote per share on major corporate matters (board elections, mergers, charter amendments)
• Dividend rights: Receive dividends only after preferred dividends are paid; not guaranteed
• Residual claim: Receive remaining assets after all creditors and preferred holders in liquidation
• Preemptive rights: May have right to maintain ownership percentage in new issuances (varies by charter)

Key characteristic: Common shareholders bear the most risk and receive the most reward. In bankruptcy, common stock typically becomes worthless.

Preferred Stock

Preferred stock sits between debt and common equity in the capital structure. Preferred shareholders receive priority over common but subordinate to bondholders.

Core rights of preferred shareholders:

• Dividend priority: Receive stated dividend before any common dividends can be paid
• Liquidation preference: Receive par value (typically $25 or $100) before common shareholders receive anything
• No voting rights: Generally cannot vote except on matters directly affecting preferred terms
• Fixed income stream: Dividend rate is fixed at issuance (similar to bond coupons)

Key characteristic: Preferred stock provides income stability and downside protection at the cost of upside participation.

Structural Comparison

Types of Preferred Stock

Cumulative Preferred

If the company skips a dividend payment, unpaid dividends accumulate and must be paid before any common dividends resume.

Example: Company issues cumulative preferred with $2.00 annual dividend. It skips dividends for 2 years. Before paying any common dividend, it must pay $4.00 per preferred share in arrears plus current dividend.

Why it matters: Cumulative feature protects preferred holders during financial distress. Most publicly traded preferred stock is cumulative.

Non-Cumulative Preferred

Skipped dividends are lost forever. The company has no obligation to pay missed dividends.

Common issuers: Banks issue non-cumulative preferred (required by regulators to qualify as Tier 1 capital). If you hold bank preferred, understand that dividends can be suspended without accumulation.

Convertible Preferred

Holders can convert preferred shares into a fixed number of common shares at a predetermined ratio.

Conversion mechanics:

• Conversion ratio: Number of common shares received per preferred share
• Conversion price: Implied price per common share at conversion (par value / conversion ratio)
• Conversion premium: Percentage above current common price at issuance

Example: Preferred stock issued at $100 par with 4:1 conversion ratio.

• Conversion price: $100 / 4 = $25 per common share
• If common trades at $20, conversion value = 4 x $20 = $80 (below par, no conversion incentive)
• If common trades at $35, conversion value = 4 x $35 = $140 (above par, conversion profitable)

Participating Preferred

After receiving stated dividend, participating preferred also receives additional dividends alongside common shareholders.

Rare in public markets: Participating preferred appears mainly in venture capital term sheets, not publicly traded securities. It gives preferred holders both downside protection and upside participation.

Dividend Mechanics and Priority

The dividend waterfall works as follows:

1. Board declares dividend from available earnings
2. Preferred dividends paid first (at stated rate)
3. Remaining earnings available for common dividends
4. If insufficient earnings, preferred receives partial payment; common receives nothing

Worked example of dividend priority:

Company situation:

• Net income available for dividends: $50 million
• Preferred shares outstanding: 10 million shares
• Preferred dividend rate: $3.00 per share annually
• Common shares outstanding: 100 million shares

Calculation:

• Preferred dividend obligation: 10M x $3.00 = $30 million
• Remaining for common: $50M - $30M = $20 million
• Common dividend per share: $20M / 100M = $0.20 per share
• Preferred yield on $50 par: $3.00 / $50 = 6.0%
• Common yield (assuming $25 stock price): $0.20 / $25 = 0.8%

If net income drops to $25 million:

• Preferred still receives full $30 million (if cumulative, arrears accumulate if not paid)
• Common receives: $0
• Preferred protected; common absorbs shortfall

Liquidation Rights and Priority

When a company liquidates (bankruptcy, merger, dissolution), claims are paid in strict order:

Liquidation waterfall:

1. Secured creditors (bank loans, mortgages)
2. Unsecured creditors (bonds, accounts payable)
3. Preferred stockholders (par value)
4. Common stockholders (residual)

Worked example of liquidation:

Company liquidating with these values:

• Assets sold for: $500 million
• Senior secured debt: $200 million
• Unsecured bonds: $250 million
• Preferred stock (10M shares at $25 par): $250 million par value
• Common stock: 50 million shares

Distribution:

• Senior secured debt: $200 million (paid in full)
• Remaining: $300 million
• Unsecured bonds: $250 million (paid in full)
• Remaining: $50 million
• Preferred shareholders: $50 million / $250 million = 20 cents per dollar of par ($5.00 per share)
• Common shareholders: $0

Result: Preferred receives $5.00 per $25 par (80% loss). Common receives nothing (100% loss). The liquidation preference protected preferred from total loss but did not guarantee full recovery.

Interest Rate Sensitivity

Preferred stock prices move inversely with interest rates, similar to bonds.

Duration approximation for preferred:

• Perpetual preferred (no maturity): Duration of approximately 15-20 years
• Callable preferred: Effective duration of 5-7 years (call limits upside)

Rate sensitivity calculation:

If interest rates rise 1%, a preferred with 15-year duration declines approximately:

Price change = -Duration x Rate change = -15 x 1% = -15%

Example: $25 par preferred drops to approximately $21.25 when rates rise 1%.

This explains why preferred stock performed poorly in 2022: rising rates from near-zero to 5%+ caused preferred indices to decline 15-25%, while common stock indices declined only 18%.

Practical Investment Considerations

When Preferred Makes Sense

• Income priority: Need reliable income stream with protection if company struggles
• Lower volatility: Prefer bond-like price stability to equity volatility
• Diversification: Adding fixed-income characteristics to equity portfolio
• Sector exposure: Financial and utility sectors dominate preferred issuance

When Common Makes Sense

• Growth orientation: Prioritize capital appreciation over income
• Voting matters: Want influence over corporate governance
• Liquidity: Common stock typically more liquid than preferred
• Tax efficiency: Qualified dividends on common taxed same as preferred; capital gains offer deferral

Tax Treatment

Both common and preferred dividends from US corporations typically qualify for preferential tax rates (0%, 15%, or 20% depending on income) rather than ordinary income rates. However:

• Trust-preferred and hybrid securities may pay interest taxed as ordinary income
• REIT preferred dividends often partially non-qualified
• Foreign preferred may not qualify for preferential rates

Common Mistakes with Preferred Stock

Mistake #1: Treating preferred like bonds

Preferred stock is equity, not debt. In bankruptcy, preferred is wiped out before bondholders take losses. Preferred dividends can be suspended (unlike bond interest, which triggers default if missed).

Mistake #2: Ignoring call risk

Most preferred is callable at par after 5 years. If you buy at $26 (4% premium) and it's called at $25, you lose 3.8% immediately. Check current price versus call price before buying.

Mistake #3: Overlooking rate sensitivity

Preferred with fixed dividends behaves like long-duration bonds. A 2% rise in rates can cause 25%+ price declines. If you expect rising rates, preferred will underperform.

Mistake #4: Ignoring cumulative vs. non-cumulative

Bank preferred is typically non-cumulative. During 2008-2009, several major banks suspended preferred dividends with no obligation to pay arrears. Know your security's terms.

Next Steps

1. Check security type before buying: Use SEC filings (8-K, prospectus) to verify whether preferred is cumulative or non-cumulative, and identify call provisions.

2. Calculate yield-to-call: If preferred trades above par and is callable, calculate return assuming it's called at first opportunity. This is often lower than current yield suggests.

3. Compare to corporate bonds: Similar credit quality corporate bonds may offer comparable yields with senior priority. Check spread differential to assess if preferred premium compensates for subordination.

4. Monitor credit ratings: Preferred ratings are typically 1-2 notches below the issuer's senior debt rating. A BBB-rated company may have BB-rated preferred (below investment grade).

5. Diversify across issuers: Preferred stock concentrates in financials (60%+ of market). Avoid overexposure to any single sector or issuer.