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.
Disadvantages of preferred shares include limited upside potential, interest rate sensitivity, lack of dividend growth, dividend income risk, principal risk and lack of voting rights for shareholders.
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 – something nobody wanted.
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. They also cannot 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.
Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.