During these times of wild market gyrations and generally lower investment returns, miniscule dividend yields on common stocks and meager CD rates, many individuals have become drawn to preferred stocks. This attraction is largely based upon the comparatively higher dividend yields of preferred stocks. Preferred stockholders not only receive their dividends before common stock investors but they are also next in line behind bondholders entitled to claim a share of a company’ financial assets in the event of dissolution. Quite a few people are jumping on the preferred stock bandwagon without taking the time to educate themselves about this complex investment vehicle. Many financial advisors will honestly say that preferred stocks are not for the “average” investor. Preferred stocks can be highly risky investments and require extensive knowledge and monitoring. A lot of people are also thrown off by the large amount of terminology associated with preferred stocks. What’s even more confusing is that there are different types of preferred stocks. Well, what is a preferred stock?
A preferred stock can be regarded as a hybrid in that it has the features of both an equity and debt security. It is an equity security because it does represent ownership in a company. It has the characteristic of a bond since it is issued as a fixed-income security which pays a fixed dividend. Although, the price of the preferred stock tends to fluctuate with changes in the interest rate, it can also be affected by the issuing company’s business performance and credit rating. However, unlike common stock, preferred stock does not confer voting rights. Some preferred stocks are issued as adjustable-rate. The dividend rate is tied to the benchmark interest rate such as Treasury bills and money market rates. Because the payment is tied to current interest rates, the price of the stock tends to be somewhat stable.
Companies typically issue preferred stock in order to raise capital. There are several types of preferred stock:
Convertible Preferred: Allows the stockholder to exercise the option of converting preferred stock into a specified number of common stock shares.
Cumulative Preferred: Refers to the accrued dividend payments that are owed to the preferred stockholders in the event that the company might have to suspend or even reduce its dividend payout. The preferred stockholders will receive the current dividends along with any dividends from the past. These dividends are always paid to preferred shareholders before common stock shareholders.
Participating Preferred: Preferred shareholders will receive the regular, stated dividend along with a share of the corporate profits. The percentage of profit varies. For example, XYZ stock has a stated preferred yield of 4% with a participating preferred yield to 8%. The corporation can issue an additional 4% in dividends if the board decides to exercise this option.
Callable Preferred: Is sometimes referred to as redeemable preferred. This type of investment allows the corporation to buy back the stock from investors at certain price after a specified date. This can enable the company to subsequently issue a new preferred dividend obligation which is lower.
Non-cumulative: This is sometimes referred to as straight preferred. Only the stated dividends are paid. Shareholders will not receive the missed dividends.
Preferred stocks are alluring to income investors because of the higher dividend. Long maturity dates usually mean a higher yield. Broadly speaking, preferreds do not have a fixed maturity date, unlike bonds. It is, in a sense, a perpetual security. The relatively low market volatility of preferred stocks does not mean that they are immune to risk. They are particularly vulnerable to call risk, interest rate risk and liquidity risk. As is the case with common stock dividends, a company can also suspend the payment for preferred dividends. Another drawback to preferreds is that they do not offer the potential for capital appreciation that common stocks hold.
Aside from purchasing individual preferred stocks, it is also possible to buy an ETF which exclusively invests in preferreds. Preferred stock mutual funds, which are classified as closed-end, have a limited number of shares and trade in the open market, present another alternative. There are very few open-end preferred stock mutual funds. Potential investors should be wary of the fact that fund performance is only one variable which requires careful scrutiny. Closed-end and open-end preferred stock mutual funds are subject to investment risk, fees and commissions. Open-end mutual funds, particularly those in the more conservative asset allocation, balanced, equity-income, growth and income and lifecycle categories, may hold a small percentage of total assets in preferred stocks. Convertible mutual funds, in addition to holding convertible bonds, may also include convertible preferred stocks in their portfolio.
For informational purposes only and not intended as advice or recommendation. Every attempt is made at accuracy, however, the author does not claim that the content is free of factual errors.