What it is:
Preferred shares represent an ownership stake in a company -- in other words, a claim on its assets and earnings. However, as the term suggests, "preferred" shares carry certain advantages. While preferred shares usually do not carry the same voting rights as common shares, they do have priority when it comes to dividends and bankruptcy. And like common shares, preferred shares can be bought and sold through a broker.
How it works (Example):
The primary difference between preferred shares and common shares relates to the order in which shareholders are paid in the event of bankruptcy or other corporate restructuring. If the issuing company seeks bankruptcy protection, then the owners of preferred shares take priority over common shareholders when it comes time to pay dividends and liquidate the company's assets.
The other main difference between preferred and common shares relates to dividends. Although dividends paid on common shares are not guaranteed and can fluctuate from quarter to quarter, preferred shareholders are usually guaranteed a fixed dividend paid on a regular basis. As a result, preferred stocks often act similar to bonds. The average dividend yield paid out on preferred shares has recently ranged from 5% to 7%. That compares to historical yields of around 6% for investment quality corporate bonds, and roughly 2% to 3% dividends for common shares.
Why it Matters:
Preferred shares are a good alternative for risk-averse investors wanting to buy equities. In general, they are less volatile than common shares and provide a better stream of dividends. Most preferred shares are also callable, meaning the issuer can redeem the shares at any time, so they provide investors with more options than common shares. But for all of these advantages, preferred shares have one downside -- its shareholders generally do not enjoy the same voting privileges as the holders of common shares. Not all investors actively participate in voting, but it may be a deterent for some investors.