Remember that preferred stocks pay a consistent dividend, much like the coupons paid by fixed income securities (bonds).
As is the case with bonds, preferred stocks are extremely sensitive to changes in interest rates. As interest rates rise, the present value of a preferred stock falls (and vice versa).
The difference is that preferreds are issued in perpetuity (they have no specified maturity date), while bonds are issued with a specified maturity date (often a maximum of 30 years).
Because preferreds are issued in perpetuity, they are even more sensitive to interest rate changes than long-term bonds. When interest rates rise, the value of preferred stock will often plummet. When interest rates decline, preferreds don’t benefit like bonds because of their call provision (discussed below).
Thus, preferred stocks are subject to asymmetric interest rate risk, which ultimately makes them unattractive to many individual investors.
3) Call Provisions
Almost all preferreds are callable at par value at the issuer’s discretion, normally following a specified amount of time past the issue date (often five years). This provision hurts preferred stockholders when interest rates decline.
If interest rates fall, the issuer will likely call the preferred stock and replace it with a new offering at a lower rate, thus lowering the company’s overall cost of capital.
Because of the asymmetric interest rate risk and call provisions, preferred stocks rarely trade above their issue price (at a premium).
4) Credit Risk
Like bonds, preferred stocks are rated by the major credit-rating companies. Preferred stocks generally receive a lower credit rating than comparable bonds for two reasons:
Preferred stock dividends do not carry the same guarantees provided by coupon payments from a bond.
In the event of a bankruptcy, all debt holders (including bond owners) are paid before preferred shareholders.
As a result, preferred stock carries substantial credit risk. In financial distress, a company will always delay or eliminate a preferred dividend before it will default on its debt.
Should You Invest in Preferred Stock?
Most investors consider investing in preferred stock as an alternative to bonds because the dividend yield can be very attractive.
If you want to draw that comparison, you must also consider overall investment risk, and preferred shares are far riskier than comparable bonds. For example, during the 2008 financial crisis, many preferred shares plummeted in value while most bonds performed very well.
One of the most widely owned, diversified preferred stock ETFs (PFF) was destroyed during this time, falling from almost $50 per share to less than $20 per share over the course of 18 months. If you are willing to accept that level of risk, common stock offers far more upside potential in times of economic prosperity.
This scenario highlights another problem with preferred stock. Because of the unique risks highlighted above, you should never own individual preferred stocks. You should buy a diversified fund that invests in a number of different preferred shares.
The annual expense ratio of most preferred funds is very high, and even high-quality options like (PFF) carry an expense ratio of 0.47% annually. On the other hand, diversified bond funds and common stock funds can be found for around 0.05% annually. The additional 0.40% in expenses will directly reduce your net return.
Ultimately, preferred stock combines the disadvantages of both common stock and bonds. Like a bond, preferred stock does not participate in future earnings growth of the issuing company. However, a bond has greater legal protections than the preferred and has a maturity date at which the principal is to be repaid. Like common stock, the preferred has fewer legal protection than the bond.
However, the potential increase in the market price of the common stock is lacking for the preferred. The only real advantage for preferred stock is a higher dividend yield, but even that is not guaranteed in times of financial distress.
If you understand the risks and are still interested in preferred stock, consider buying a high-quality, diversified ETF during times of market turmoil. During these times, many preferred shares can be purchased at a steep discount to par value – providing growth potential and a large dividend yield.
This article was republished with permission from Cash Cow Couple.