Like shares of common stock, 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" stock carries certain advantages.

The primary difference between preferred stock and common stock 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 stock 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 stock 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 stocks.

Risk
Because they act similar to bonds, preferred shares are exposed to interest rate risk. When interest rates rise, preferred stock can decline in value. Preferred shares also tend to move more slowly to the upside than common stock. Most preferred shares are also callable, meaning the issuer can redeem the shares at any time. And finally, preferred shareholders generally do not enjoy the same voting privileges as the holders of common stock.

Ratings
Like corporate bonds, most preferred stocks are rated by one of the major ratings agencies -- the largest and most widely known being Standard & Poor's and Moody's. If a preferred stock is rated only by one of the smaller rating agencies, such as Duff & Phelps or Fitch, then investors should be aware that the organization may not have been able to obtain a positive rating from either S&P or Moody's.

Terminology

Cumulative
Most preferred dividends are cumulative. As a result, if a company's Board of Directors temporarily suspends the payment of quarterly dividends, then the accrued dividends of preferred shareholders will take priority over common stock dividends upon resumption of the payment. In other words, all current dividends – plus previously unpaid dividends -- on preferred shares must be entirely paid off before the firm can pay dividends to common shareholders.

Callable
Like bonds, most preferred stocks can be called. This means the issuer has the right to redeem the shares after a specified date.

Convertible
Convertible preferred stock can be exchanged for common stock at a set price after a certain date.

Participating/Non-participating
When preferred stock is participating, this means that when specific conditions are met, shareholders may be entitled to receive additional shares.

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