A preferred stock is an equity investment that shares many characteristics with bonds, including the fact that they are issued with a face value. Like bonds, preferred stocks pay a dividend based on a percentage of the fixed face value. The market value of a preferred stock is not used to calculate dividend payments, but rather represents the value of the stock in the marketplace. It's possible for preferred stocks to appreciate in market value based on positive company valuation, although this is a less common result than with common stocks.
Key Takeaways
- Preferred shares are a hybrid securities issued by corporations marrying certain traits of equity and fixed income investment.
- Preferred shares are issued with a face value, but this is effectively an arbitrary price chosen by the issuing company.
- Because preferred shares pay steady dividends, but lack voting rights, they will typically trade in the market for a value different from the same firm's common shares.
- Some preferred shares are callable, which means the issuer can recall them from investors, so these will sell at a discount. Others are convertible into common shares.
Share Price vs. Bond Par Value
The par value of a fixed income security indicates the amount that the issuer will pay to the bondholder when the debt matures and must be paid back. Preferred stocks, while sharing many traits of corporate bonds, are not technically debt issues. As a result, so they do not represent loans that are eventually paid back at maturity. Some companies do issue preferred stocks with a maturity date and retract the stock on that date. The bondholder is compensated by the amount listed on the face value. Practically speaking, this is no different than a bond maturity in most cases. However, a retractable preferred stock is not a debt security like a bond.
The market prices of preferred stocks do tend to act more like bond prices than common stocks, especially if the preferred stock has a set maturity date. Preferred stocks rise in price when interest rates fall and fall in price when interest rates rise. The yield generated by a preferred stock's dividend payments becomes more attractive as interest rates fall, which causes investors to demand more of the stock and bid up its market value. This tends to happen until the yield of the preferred stock matches the market rate of interest for similar investments.
Share Price vs. Callable Price
Some investors confuse the face value of a preferred stock with its callable value – the price at which an issuer can forcibly redeem the stock. In fact, the call price is generally a little higher than the face value. Callable preferred stocks are not the same as retractable preferred stocks that have a set maturity date. Companies might exercise the call option on a preferred stock if its dividends are too high relative to market interest rates, and they often re-issue new preferred stocks with a lower dividend payment. There is no set date for a call, however; the corporation can decide to exercise its call option when the timing best suits its needs.
In effect, the face value of a preferred stock is the arbitrarily designated value generated by the issuing corporation that must be repaid at maturity. It is significant in determining dividend payments, though not necessarily yield. The market value is the actual price at which the security trades on the open market and the price that fluctuates when yield is reacting to interest rate changes.
What the Experts Have to Say:
Advisor Insight
Russell Wayne, CFP®
Sound Asset Management Inc., Weston, CT
The face value is an arbitrary value set by the issuing company. At some future point, it may be the value at which the firm redeems the shares, but there's no guarantee. If the preferred shares are callable, the company would repurchase them at the call price, which may or may not be the same as the face value.
The stock’s market value is far more important. It’s determined largely by its dividend yield. For example, if a stock pays a $1 annual dividend and its market price is $25, the annual yield is 4%. A rise in interest rates would have a negative impact: a 25% jump might make the share price drop to $20, which would then provide a yield of 5%. Similarly, if rates fell, the shares’ price would rise by a proportionate amount to keep the dividend yield in line with the prevailing rate.
Preferred stocks are fascinating investments that blend elements of both equity and fixed income securities. They carry traits akin to bonds but have distinct features that set them apart. These stocks are issued with a face value, much like bonds, yet they function as equity investments. Their dividends are based on a percentage of this fixed face value, not the market value, which differs significantly from common stocks.
The market value of preferred stocks fluctuates based on various factors, primarily driven by the company's valuation. Although they can appreciate in value due to positive company performance, this occurrence is less common compared to common stocks.
The par value of fixed income securities, including bonds, signifies the amount the issuer repays the bondholder upon maturity. However, preferred stocks, despite sharing characteristics with bonds, don't technically represent debt issues and lack a set maturity date in most cases. While some companies issue retractable preferred stocks with maturity dates, these stocks are not debt securities.
Callable preferred stocks are distinct from retractable ones and are callable by the issuer at a price generally higher than the face value. Companies may exercise the call option if the dividends on the preferred stock surpass prevailing market interest rates. This action allows corporations to reissue new preferred stocks with reduced dividend payments.
The market prices of preferred stocks often behave akin to bond prices, especially if they possess a set maturity date. They tend to rise when interest rates fall and decline when rates rise. This movement is driven by the attractiveness of the yield generated by dividend payments relative to market interest rates.
The face value of preferred stocks, while significant in determining dividend payments, doesn't necessarily determine yield. On the other hand, the market value reflects the actual price at which these stocks trade in the open market, fluctuating in response to changes in yield due to interest rate shifts.
Experts like Russell Wayne emphasize the importance of a preferred stock's market value over its face value. Market value, largely driven by dividend yield, is influenced by fluctuations in interest rates. Changes in interest rates can significantly impact a stock's price, causing adjustments to maintain the dividend yield in line with prevailing rates.
Understanding these distinctions is crucial for investors navigating the complexities of preferred stocks and their valuation dynamics.
