In your early years as an investor, you'll probably put most of your money into mutual funds. They make sense because they're easy to invest in and it doesn't take a big investment to get started. Over time, as your portfolio grows and your priorities change, you might start investing directly in stocks and related products. Ordinary equity stocks represent part-ownership of a company. Preferred stocks and their close kin, preferred trust stock shares, are different.
Conventional vs. Preferred Stocks
Conventional stocks are typically referred to as shares, because each one represents a share in the issuing company's equity. When the value of the company increases, the value of each share increases to the same degree, creating a capital gain. Some companies also pay a dividend, a portion of retained earnings, to each share. Preferred stocks are different. They have no ownership stake in the company, but exist solely to earn dividend income. Unlike regular shares, they don't include voting rights. However, their dividends are guaranteed and if the company fails, these shareholders have a priority claim on the company's assets.
Preferred Stocks in Depth
Although preferred stocks are traded like equity stocks on the stock market, their predictable and relatively high yield is more like the behavior of a bond. This makes them attractive to more conservative investors. Some preferred shares are "cumulative," which means the company can legitimately miss payments but make them up later. Some are "callable," meaning the company can call them in and replace them with new preferred shares at lower dividend rates. "Participating" preferred shares can receive additional dividends from the company during prosperous times. Many preferred shares are also "convertible," meaning their owner can exchange them for conventional equity shares.
Trust Preferred Shares
Many companies have embraced a different method of raising investment capital using a trust. Essentially, it places the investor at arm's length from the issuing company. Rather than issuing preferred shares directly in the company, the firm sets up a standalone trust as a subsidiary. The trust purchases a bond or other debt security from the parent company, then issues preferred shares in the trust itself. The trust collects interest income from the parent company and uses those funds to issue distributions to its investors. The parent company earns a tax deduction on the interest it pays to the trust, a clear benefit.
Preferred shares in the trust work much like bonds. When the trust buys debt from the parent company, that debt has a maturity date at which it's paid out. Shares in the trust have the same maturity date and must be redeemed, or sold back, at the end of the term. Interest income from the trust shares can be deferred for as long as five years, though you'll need to pay taxes each year on the amount of deferred interest owed to you. You can avoid this by holding the shares in your IRA, where the income can grow tax-free.
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