Indexology: 5 Risks Associated With Investing in Preferreds

Due to their hybrid nature, the potential risks of preferred securities are related to the interest rate environment, issuer’s credit quality and liquidity.

1. Interest Rate Risk: Due to their bond-like fixed dividend payments, preferreds are vulnerable to changes in interest rates.  There is an inverse relationship between preferred prices and changes in interest rates.  In a rising interest rate environment, preferred stock prices fall as the present value of future dividend payments decreases.
2. Reinvestment Risk: A preferred investor who does not seek high current income in dividend payments would be faced with the risks and associated costs of reinvesting the regular dividend payments.  Callable shares carry an even greater reinvestment risk, as there is the potential for the company to redeem the shares.  This would force the investor to give up the shares at par, or a specified call price.
3. Liquidity Risk: Preferred shares are less liquid than common shares.  Therefore, trading these securities may involve higher market impact costs and bid-ask spread costs.
4. Credit Risk: If a company is facing liquidity problems or poor performance, it may not be able to pay out the dividend to investors.  Unlike bondholders, preferred shareholders have little recourse if a company does not pay the dividend.
5. Sector Concentration Risk: Financial companies are the primary issuers of preferreds in the U.S.  A portfolio of preferred securities would be subject to the sector-specific risk factors of the financial sector.

Contributors:
Phillip Brzenk, CFA
Associate Director, Index Research & Design

Aye Soe, CFA
Director, Index Research & Design