This article will help you understand the characteristics that define both types of stock, and can help you decide if preferred stock belongs in your investment portfolio.
What is Preferred Stock?
Preferred stocks (sometimes called “preferreds”) are a type of stock with bond-like features.
Most preferred stocks pay a regular dividend that is very similar to the regular coupon payments offered by bonds. For example, a preferred share might offer a 6% dividend yield. If you purchase a share for $100, you could expect a $6 annualized dividend payment.
Also like bonds, the market value of each preferred share fluctuates with respect to interest rate changes and the issuer’s creditworthiness. The value also partially depends on the business performance and earnings potential of the issuer (to a lesser degree than common stock).
While most bonds have a fixed maturity date, preferred stock is often issued in perpetuity. To recoup your initial investment, you generally must sell the shares to another investor. For this reason, many preferred shares are sold at a discount to the initial face value on the secondary market.
The stock is called “preferred” because shareholders receive preference over common stockholders with regard to dividend payments and bankruptcy claims.
Why Do Companies Issue Preferred Stock?
Companies issue all forms of equity (and debt) for one reason – to raise capital that can be used to improve the business.
Many companies that issue preferred shares are required by regulators to have adequate capital to support their debt liabilities, and preferred stock is a relatively cheap way to maintain a healthy debt-to-equity ratio. Although preferred shares behave much like bonds, they are treated as equity on the balance sheet. This is important because too much debt can result in a downgraded bond rating by the rating agencies, which can lead to a number of other corporate problems.
Perhaps even more importantly, preferred dividends can be suspended if a company faces financial hardship, while bond interest payments cannot. If a company misses the interest payment on a debt security, it can be considered in default and risks being forced into debt reorganization.
Another reason that companies issue preferred stock is to restrict voting rights. Common stockholders can vote to appoint the company’s board of directors, among other things. Preferred stockholders typically do not receive voting rights, and therefore have less influence on corporate policy decisions. Companies that want to limit the control they give to shareholders can issue preferred stock as an alternative (or supplement) to common stock.
What are the Advantages of Preferred Stock?
1) Consistent Income
The dividends provided by preferred stock can be an excellent and predictable source of income. In many situations, preferreds offer a much higher yield than corporate bonds.
2) Preferred Status
Dividends must be paid on the preferred stock before any common stock. Furthermore, most preferred dividends are cumulative. If a company fails to pay a dividend in full, the company must make payment at a later date. No common stock dividends can be paid until all preferred dividends are paid.
In situations of financial distress where the company must be sold or reorganized, the interests of preferred shareholder are usually placed ahead of common stockholders, but always behind the debt holders (bond owners).
3) Tax Advantages
Many preferred dividends are considered “qualified” by the IRS and taxed at a preferential rate (the same rate as long-term capital gains).
In contrast, corporate bond interest is taxed as ordinary income.
4) Convertibility
Convertible preferred stock contains a provision that allows the holder to convert the preferred stock into common stock under certain conditions. The provision usually states a future date when conversion may begin and specifies the conversion rate from preferred to common stock.
This feature allows preferred shareholders to share in the potential upside of the underlying common stock. However, not all preferred stock offers this provision.
What are the Disadvantages of Preferred Stock?
1) Limited Growth Potential
Common stockholders share in the growth of a company through higher stock prices over time (capital appreciation), while the return on preferred stocks is almost entirely a function of the dividend yield. Preferred shareholders receive limited benefits following an improvement in the issuing company’s earnings.
If the preferred stock can be converted into common stock, this problem largely disappears. But many preferred shares cannot be converted.
2) Interest Rate Risk
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.