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Ask a Fool: What Is a Preferred Stock?

Q: What is a preferred stock, and how is it different from common stock?

Common stocks are what you generally think of when you hear the word "stock." They represent a share of equity in the underlying company, and their share prices and dividends can go higher or lower depending on how profitable the company is.

On the other hand, a preferred stock is more akin to a bond. Companies issue preferred stock to raise capital, and agree to pay investors a certain interest rate. The rate can either be fixed or variable, and is based on the preferred stock's par value -- usually $25. It's important to note, however, that the share price fluctuates over time.

Most preferred stocks are issued by financial-sector companies, like banks, but it's not uncommon for preferred stocks to be issued by companies in other industries.

There are a few key differences between preferred stocks and bonds. One advantage is that preferred stocks trade on major stock exchanges and are generally more liquid investments. They are also more accessible for smaller investors, as bonds typically sell in $1,000 increments.

A potential downside of preferred stock is that shareholders are lower in priority than bondholders (but higher than common stockholders) in the event that the company goes bankrupt. For this reason, preferred stocks typically pay higher interest rates than bonds issued by the same company.

As an example, one particular series of Bank of America's preferred stock has a par value of $25 and an annual dividend of $1.50, for a 6% yield. However, the shares are currently trading for $26.56, which makes the effective yield 5.7%.

The bottom line is that while preferred stocks can be slightly riskier than bonds, as long as they're issued by rock-solid companies, they can be an excellent way to add income to your portfolio.

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Matthew Frankel owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.