Great question. To answer this properly, we need to understand what are common stocks, bonds, and preferred stocks.
Youâre probably going, âWhyâre you talking about bonds, sia?â
Relax. I got you, fam.
TL;DR: Why Preferred Stocks = Low Liquidity?
Preferred stocks
- Have fixed dividends = free money
- Are callable = capital 'guaranteed' in a way
Investors more likely to hold than sell = low trading volume = low liquidity
Haha. Sorry.
About Common Stocks
When investors talk about the 'stock' market, they're all referring to common stock because companies don't usually issue preferred stocks.
Common stocks or stocks are the most common way for a company to raise money for its business. So when investors buy stocks, theyâre buying common stocks.
When investors buy stocks, theyâre technically buying a stake in the company. And as 'owners', they have the right to vote during shareholder meetings and also receive dividends - if the company pays them.
If the company does well and stock price increases, thatâs when investors will see a capital gain.
About Bonds
Iâm gonna side track a bit here.
When raising money to expand its business or operations, a company can choose to issue stocks OR bonds. So why stocks instead of bonds?
One word: Debt.
A bond is where the company promises to pay a preset amount of interest annually for the life of the bond. Once the bond matures, the company also has to pay the bondholder the bondâs principal.
You can also see why this would NOT be a good deal for companies because in the off chance that they go bankrupt, the company would have to sell their assets in order to pay off the bonds (aka debt).
With stocks, a company has no such financial obligation.
This is why stocks are a riskier asset for investors, but they also reward them accordingly. Especially if you can pick a company that grows exponentially without debt to slow it down.
So What Are Preferred Stocks?
Now that you understand what a stock and a bond is, it would make more sense to you if I explain that preferred stocks are more like bonds than a stock.
Like bonds, preferred stocks:
- Pay set dividends on a regular schedule eg. quarterly
- Have a par value (a fixed price which the company can buy back the preferred stock from you) and are callable (more on this in a bit)
- Are sensitive to interest rates The last point is particularly interesting as - like bonds - the value of preferred stocks rise when interest rates fall, and vice versa.
The reason why the prices of issued bonds and preferred stock rise when interest rates fall is because these investments pay better than lower-yielding assets. Like bonds, the company STILL has to pay preferred shareholders the set dividend, even if the market price of the stock tanks.
And should a company go bankrupt, they must sell their assets and pay, in this order:
- Creditors & Bondholders
- Preferred stock holders
- Common stock holders
You see why preferred stocks are called preferred now?
Why Do Preferred Stocks Have Such Low Liquidity As Compared To Common Stock?
We've established earlier that preferred stocks are a hybrid between bonds and common stocks.
And like bonds, the investors who hold preferred stocks do so because of the set dividends (aka recurring income).
In the US for example, institutional investors will buy and hold preferred stocks because IRS rules allow US companies that pay corporate income tax to exclude 70% of the dividend income they receive from their taxable income.
But I digress.
Another thing to note about preferred stock is that they are callable. Meaning the company has the right to buy back the shares at the par price. So as an investor, youâre always 'guaranteed' your capital - provided you bought the preferred stock at par price of course.
To summarise, preferred stocks:
- Have fixed dividends = free money
- Are callable = capital 'guaranteed' in a way
If you own a preferred stock, would you want to sell it? Or hold onto it till the price is right?
Great question. To answer this properly, we need to understand what are common stocks, bonds, and preferred stocks.
Youâre probably going, âWhyâre you talking about bonds, sia?â
Relax. I got you, fam.
TL;DR: Why Preferred Stocks = Low Liquidity?
Preferred stocks
Investors more likely to hold than sell = low trading volume = low liquidity
Haha. Sorry.
About Common Stocks
When investors talk about the 'stock' market, they're all referring to common stock because companies don't usually issue preferred stocks.
Common stocks or stocks are the most common way for a company to raise money for its business. So when investors buy stocks, theyâre buying common stocks.
When investors buy stocks, theyâre technically buying a stake in the company. And as 'owners', they have the right to vote during shareholder meetings and also receive dividends - if the company pays them.
If the company does well and stock price increases, thatâs when investors will see a capital gain.
About Bonds
Iâm gonna side track a bit here.
When raising money to expand its business or operations, a company can choose to issue stocks OR bonds. So why stocks instead of bonds?
One word: Debt.
A bond is where the company promises to pay a preset amount of interest annually for the life of the bond. Once the bond matures, the company also has to pay the bondholder the bondâs principal.
You can also see why this would NOT be a good deal for companies because in the off chance that they go bankrupt, the company would have to sell their assets in order to pay off the bonds (aka debt).
With stocks, a company has no such financial obligation.
This is why stocks are a riskier asset for investors, but they also reward them accordingly. Especially if you can pick a company that grows exponentially without debt to slow it down.
So What Are Preferred Stocks?
Now that you understand what a stock and a bond is, it would make more sense to you if I explain that preferred stocks are more like bonds than a stock.
Like bonds, preferred stocks:
The reason why the prices of issued bonds and preferred stock rise when interest rates fall is because these investments pay better than lower-yielding assets. Like bonds, the company STILL has to pay preferred shareholders the set dividend, even if the market price of the stock tanks.
And should a company go bankrupt, they must sell their assets and pay, in this order:
You see why preferred stocks are called preferred now?
Why Do Preferred Stocks Have Such Low Liquidity As Compared To Common Stock?
We've established earlier that preferred stocks are a hybrid between bonds and common stocks.
And like bonds, the investors who hold preferred stocks do so because of the set dividends (aka recurring income).
In the US for example, institutional investors will buy and hold preferred stocks because IRS rules allow US companies that pay corporate income tax to exclude 70% of the dividend income they receive from their taxable income.
But I digress.
Another thing to note about preferred stock is that they are callable. Meaning the company has the right to buy back the shares at the par price. So as an investor, youâre always 'guaranteed' your capital - provided you bought the preferred stock at par price of course.
To summarise, preferred stocks:
If you own a preferred stock, would you want to sell it? Or hold onto it till the price is right?