The Difference Between Preferred Stock & Convertible Preferred Stock
- Preferred shares are subordinate to bondholder claims within any corporate structure. Corporations are legally bound to meet interest payments--but can pay cash dividends on stock at their discretion. Preferred shares, however, carry superior asset claims over those associated with common stock. In general, dividend payments must be made on preferred shares before common shareholders receive dividends. Amid corporate bankruptcy, both preferred and convertible preferred stockholders are to receive income from any liquidated assets prior to the common shareholders.
Prices on common stock must advance to a particular point for the conversion to be economical. For example, you may be able to convert one share of convertible preferred stock into two shares of common stock. At equilibrium, one share of convertible preferred stock would be worth $100, and one share of common stock would be worth $50. Your investment stake would still then be worth $100 ($50 x 2) after conversion. If common shares were trading for only $20, you would not convert because your investment holdings would now only be worth $40 ($20 x 2) after conversion. - Dividends paid on convertible preferred shares are generally lower than those paid out on the preferred stock. This trade-off arises because investors who buy convertible preferred shares are willing to accept lower dividend payments in exchange for the right to convert to common stock. Higher dividend payments on the straight preferred shares are more attractive to conservative investors in search of investment income.
- Convertible preferred shares are more volatile than preferred shares. Convertible preferred share prices shift with the performance of the associated common stock. Prices for convertible preferred stock may fall dramatically due to weak prices on common stock. Preferred share prices, however, move in accordance with interest rates. Higher interest rates adversely affect preferred stock valuations because new bonds offer higher interest income relative to existing preferred dividends. Interest rate trends often take several months to demonstrate significant change, whereas stock prices fluctuate every trading session.
- Although convertible preferred shares can be exchanged for common stock, the common stock cannot be converted back into preferred shares.
- Preferred stock dividends are exposed to inflationary risks, or lost purchasing power over time. Inflationary risks are especially heightened with perpetuities, which are preferred shares that pay fixed dividends--with no maturity date. Participating preferred shares do offer dividend increases as profits grow for the underlying business.