Hybrid form of financing

Stock represents ownership in a company, but not all stock is created equal. A company might issue a number of classes of stock, each class with different properties. For example, XYZ company might issue Class A common stock, Class B common stock that includes 10 votes per share and Class C preferred a stock with a fixed dividend. The company’s preferred shares offer certain advantages over other classes of stock, but they have some drawbacks.

  • Current Income

Preferred stocks are a hybrid type of security that includes properties of both common stocks and bonds. One advantage of preferred stocks is their tendency to pay higher and more regular dividends than the same company’s common stock. Preferred stock typically comes with a stated dividend. The company is not obligated to pay the dividend and is not considered in default if it misses a preferred dividend payment as it would be if it missed a bond payment. The company is obligated to pay any missed preferred dividend payments before it makes any dividend payment on its common stock.

  • Ownership

Both bonds and preferred stocks are considered fixed income securities because the amount of regular interest or dividend payments is a known factor. The market price of both Bonds and preferred stocks is heavily influenced by movements in prevailing interest rates. Unlike bonds, which are debt instruments and don’t confer any ownership in the company, preferred stocks are equity instruments. Preferred shareholders own a piece of the company. If the company does well, the value of the preferred stock can appreciate independently of interest rate movements.

  • Preferential Treatment

In a worst-case scenario, a company might be forced to liquidate its assets to pay its creditors. The company’s bondholders have the first right to the company’s assets, before the preferred stockholders. Once the bondholders have been made whole, the company’s assets are available to the company’s preferred stockholders. Any assets left after the preferred stockholders are paid are divided among the common stockholders.

  • Disadvantages

Preferred stock typically does not include the right to vote at the company’s annual stockholders’ meeting. The market price of the preferred stock is interest-rate sensitive and can decrease sharply during periods of rapidly rising interest rates. Since the board of directors can elect to suspend dividend payments, there is no guarantee that preferred stock will maintain its regular stream of current income.