Preferred Stocks: Should You Invest in Them?

When you invest in stocks it’s almost always in common stock.

But there’s a whole other class of stock that few people invest in, and only a small number know anything about.

Preferred stock is an entirely different class of stock, and has as much in common with bonds as it does with common stock.

What are preferred stocks and should consider them as part of your investment portfolio?

What are Preferred Stocks?

First and foremost, preferred stocks are stocks, not bonds.

• Bonds are corporate securities issued for a specific term, that pay a fixed interest rate, and return the full principal invested to investors upon maturity.
• Stocks represent ownership in a publicly traded corporation, otherwise known as equity.

As a preferred stockholder, you’ll participate in both the profits of the corporation, as well as any gain in the value of your stock.

There are two primary types of stocks, common and preferred.

Common stock

Common stocks are the ones most popularly quoted and followed in the financial media, as well as held in mutual funds and exchange-traded funds (ETFs).

Preferred stock

Preferred stock is something of a special class of stock.

Primarily:

Preferred shareholders take priority over common stockholders in the payment of dividends.

In most cases, the dividend yields paid on preferred stock are higher than what they are for common stock.

This makes preferred stock more popular among income investors.

Dividends paid on preferred stock can be either a fixed amount, or type tied to an independent index, like the London InterBank Offered Rate, or LIBOR.

However, the dividend rate may also be set on an adjustable-rate basis.

The stock offer may specify certain situations that can affect the dividend yield one way or another.

For example, the company can pay a higher dividend based on higher profits.

Preferred vs. Common Stock

As described above, preferred stockholders will receive their dividends ahead of common stockholders.

Moreover:

It’s even possible the company will cut the dividend paid to common stockholders while paying the full dividend on preferred stock.

This is the basic reason for inclusion of the word “preferred” in the stock description.

But the preference goes beyond payment of dividends.

Priority claim

Should the company liquidate, preferred stockholders hold a priority claim on the assets of the company over common stockholders.

That doesn’t guarantee preferred stockholders will be fully reimbursed for their investment.

In a corporate liquidation, there are other categories that take priority over preferred stocks, such as bonds, payroll, taxes, and other corporate obligations.

The preferred stockholder is never certain to receive his or her full investment, but whatever received will be greater than that paid to common stockholders.

Bond-like qualities

In that way:

Preferred stocks are something of a hybrid between common stock and bonds.

Like bonds, they pay steady dividends and get in line ahead of common stock upon corporate liquidation.

But like common stocks, the value of preferred stocks can fluctuate, there is no maturity date, and the company has no obligation to repay stockholders their original investments.

For that matter, a corporation has no obligation to pay dividends at a certain rate, or even pay them at all.

Like common stocks, the dividend payout rate can be raised, lowered, or eliminated completely. With bonds, the corporation is legally obligated to pay the stated rate of interest for the full term of the issuance.

Voting rights

There’s one other significant difference between preferred and common stock, and that’s voting rights.

Common stockholders have full voting rights in corporate governance.

Preferred stockholders will have limited voting rights at best, but like bondholders, they typically have no voting rights whatsoever.

Factors that Affect the Value of Preferred Stocks

The major factor affecting the value of preferred stocks is interest rates.

Because preferred stocks function more like bonds – investors buy them primarily for income – than common stocks, they’re highly interest-rate sensitive.

Put another way:

They’re subject to interest rate risk.

Interest-rate risk is the risk that interest rates will rise, causing the value of the underlying security to fall.

Conversely, when interest rates fall, the value of the underlying security will generally rise.

An example:

Let’s say a preferred stock is trading at $100 and paying an annual dividend of $5, for a 5% yield.

But within a year, interest rates rise by 1%. Because preferred stock is interest-rate sensitive, the dividend yield on the stock will need to increase to 6%.

For that to happen, the value of the stock will fall to $83 per share, for a 17% decline.

Conversely, using the same stock and dividend, if interest rates were to fall by 1%, the value of the stock could increase to $125 per share.

At that price, the $5 dividend payout would produce an annual yield of 4%.

At the same time, an increase in the dividend paid on preferred stock can also cause the stock to rise in value.

A cut in the dividend would cause the share price to fall.

This highlights the reality that preferred stock prices are determined primarily by interest rates, and not by corporate profitability the way common stock is.

Because of the connection with interest rates, preferred stock generally provides far less capital appreciation than common stock.

It’s possible for common stock to double in value while the preferred stock in the same company rises by only a few percentage points.

Relation to Preferred Bonds and Dividends

So far, we’ve been talking about the relationship of preferred stocks to common stocks.

But there is a similar connection between preferred stocks and bonds.

In the section above, we covered interest-rate sensitivity.

This is a feature of bonds as much of it is for preferred stock. The value of a long-term bond is primarily determined by changes in interest rates.

Similar to preferred stock, the value of the bond can decline if interest rates rise, and increase if rates fall.

But that’s not the only similarity between preferred stock and bonds.

Like preferred stock, people invest in bonds primarily for income.

Though it is possible to get capital appreciation on both bonds and preferred stock, that will only happen if interest rates fall.

Or in the case of preferred stock, if the dividend is increased. But since neither situation can be guaranteed or predicted, income is the only certainty.

In another similarity to bonds, preferred stocks typically have credit ratings from bond rating agencies, like Standard & Poor’s, Moody’s, and Fitch.

If one or more of those agencies were to downgrade the rating on the preferred stock, the value can drop.

That’s because the ratings largely determine the likelihood the company will be able to continue paying the stated dividend rate.

Other Features of Preferred Stock to Be Aware Of

Preferred stock can be callable.

That means:

The issuing company can repurchase the shares at par value at a predetermined date.

This is a distinct possibility if interest rates fall, and the company feels it can issue a new series of preferred stock paying a lower dividend rate.

Preferred stock also may be convertible.

This means that while it’s purchased as preferred stock, it can be exchanged for a certain number of common stock in the same company in predetermined circumstances.

If the stock is convertible, conversion may occur upon a vote by the board of directors, or the investor may have the option to complete the conversion by a specific date spelled out in the terms of the stock issue.

How Do You Buy Preferred Stock?

Though preferred stocks are most commonly purchased by institutional investors, like pension funds and insurance companies, they’re often available for individual investors as well.

Like common stocks, they can be purchased through investment brokerages that deal in preferred stock.

This will typically be the larger investment brokers, as smaller, more specialized brokers may offer a limited investment menu.

Pros

• Good for income investors, since they often pay dividend yields higher than interest rates paid on bonds.
• Dividends on preferred stock will be paid ahead of dividends on common stock.
• You’re more likely to recover at least some of your investment in a corporate liquidation than you are with common stocks.
• Limited capital appreciation is possible if either interest rates fall or the company increases the dividend paid on the stock.
• Preferred stock may be convertible into common stock, which may be an advantage under certain circumstances.

Cons

• Preferred stock doesn’t offer the capital appreciation potential of common stock.
• Preferred stock is interest-rate sensitive, and can fall in value in a rising rate environment.
• There are no voting rights.
• Preferred stock may be callable, forcing you to redeem your investment before you’re ready.
• Companies that issue preferred stock often do so because they are heavily leveraged, and unable to raise financing through additional bond issues.

Conclusion

From an investor standpoint, preferred stock functions more like fixed-income investments than like equities.

For this reason:

It may be best suited for the bond portion of your portfolio.

Preferred stock typically pays higher dividend yields than common stock, and often higher than bonds.

But just be aware that they are also stocks at the core, and in no way provide a guarantee of investment value. While they can produce a limited amount of capital appreciation, there’s an equal likelihood they can decline in value.

If you’re going to invest in preferred stock, know what you’re getting into, and tread lightly!