Preferred shares: a bond that calls itself a stock.

01Where preferred sits in line

When a company pays out money, or is liquidated, there is a queue. Lenders and bondholders come first. Next come preferred shareholders, who must get their dividend before common shareholders can get any. Common shareholders come last, and take whatever is left, which is unlimited on the way up and nothing on the way down.

That place in line matters while the company is paying, not when it is failing: by the time the lenders are paid there is usually little or nothing left for anyone behind them.

Preferred holders give up the upside to stand ahead of the common shares. They usually have no vote either. What they get is a dividend set by the share terms, which the company can't raise just because it is doing well.

02The terms that matter

• Par value and dividend rate. Many US retail preferreds are issued at $25 a share. A 6% preferred pays 6% of $25, or $1.50 a year.
• Cumulative or not. If a cumulative preferred's dividend is skipped, the missed payments pile up and must be paid before common shareholders get anything. A non-cumulative dividend, once skipped, is gone.
• Perpetual or with a set end. Many preferreds have no maturity date: the company never has to repay the $25.
• Callable. The company can usually buy the shares back at a set price, often par, after a set date.
• Rate reset. Common in Canada: the dividend rate is reset every five years to the five-year Government of Canada bond yield plus a fixed spread. That flips the bet in the chart below: when rates fall, the next reset will cut the dividend, so the price falls; when rates rise, it is cushioned. The perpetual in the chart is the plain case.

03Priced like a bond that never ends

A perpetual preferred is a stream of fixed dividends with no end date. Its fair price is the dividend divided by the yield the market demands on that kind of security:

04The call: heads they win

If yields fall to 5%, the formula says the $1.50 dividend is worth $30. But the company can call the shares at $25 and issue new ones paying only 5%. Buyers know that, so the price tends to stall near the call price instead of rising to $30. If yields rise, no such cap applies: the price falls all the way down the curve.

So the holder keeps the downside when rates rise and gives up most of the upside when they fall. That lopsided deal, along with standing behind every lender and a dividend the company can skip, is why preferreds usually yield more than the same company's bonds.

05How a holder makes money

Mainly through the dividend, paid quarterly in most cases. Price gains are limited by the call, and price losses come when rates rise or the company's credit weakens. A preferred bought below par can gain if the company later calls it at par, or if rates fall back.

06What can go wrong

• Rates rise, and a perpetual preferred falls hard, with no maturity date to wait for.
• The call takes the shares away when holding them is most attractive.
• Dividends can be suspended: unlike bond interest, a skipped preferred dividend is not a default, and a non-cumulative one is simply lost.
• Credit: in a failure, preferred holders are paid only after every lender.
• Thin trading: many preferreds trade lightly, so spreads can be wide.