Preferred Stock: a Hybrid Investment
Posted by Richard on July 9, 2014
With interest rates on government bonds and highly rated corporate bonds barely keeping up with inflation, investors are searching far and wide for better returns. One alternative is preferred stock.1 Preferred stock is often called a stock-bond hybrid. While technically an equity investment, shares of preferred stock pay a dividend, usually on a quarterly basis.2 The yields typically range from 4% to 8%, but some issues generate 10% or more.
Preferred stock generally does not have the same volatility as common stock — shares usually have a par value of $25 (although some shares have a par value of $50 or $100) and can trade for a premium or a discount. They have low correlations with both common stock and bond returns. Preferred stocks do not have maturities. They remain in the market until they are called by the issuer, usually with only 30 days notice.
Understanding Preferred Stock
Preferred stock can be bought just like common stock, but it has many variables. You can get key information on the type of preferred stock being issued by reading its prospectus, which will tell you the following:
- Cumulative vs. noncumulative — Most preferred issues are cumulative, which means that the dividends will accrue even if they are not paid each quarter.
- Convertible vs. nonconvertible — Convertible preferred stock can be exchanged for common stock, usually after a set date at a certain price. This allows the shareholder to lock in the dividend income and potentially profit from a rise in the common stock while seeking protection from a fall.
- Voting vs. nonvoting — Shares of preferred stock may or may not give the owners voting rights. Most do not, but in some cases, preferred shareholders will receive voting rights if dividends have not been paid for a specified length of time.
- Participating vs. nonparticipating — Participating shares may receive additional dividends. These can be based on a stipulated percentage of either the net income or the dividend paid to the common stockholders.
- Adjustable vs. fixed — Most preferred stock is fixed rate. In the case of adjustable rate, shareholders receive a dividend that differs based on any number of factors determined by the company at the issue’s initial offering.
Risks of Preferred Stock
Investors in preferred stock face a number of risks.
- Default risk — In the event of a bankruptcy, preferred stockholders are paid before common stockholders, but after creditors and bondholders.
- Interest rate risk — If interest rates decline, the issuer may decide to buy back the existing preferred shares in order to issue new ones at a lower rate. If rates go up, the holder of the preferred shares might be left holding a security that pays less than the market rate for many years or in perpetuity, effectively reducing the value of the holding.
- Lack of price appreciation — Unlike common shares, which might appreciate as company earnings rise, any company growth has minimal effect on the preferred share price. However, if the company goes into a tailspin, that preferred stock dividend could be threatened, hurting its share price.
- Early callbacks — Companies that issue preferred stock hold a call option, which allows them to redeem the securities at face value after a certain period, usually five years. Doing so can deprive investors holding those shares of additional years of guaranteed income they thought they had locked in, not to mention any price appreciation on the shares, which issuers could buy back at par value.
- Liquidity risk — Some preferred stocks are not widely followed and are lightly traded. Those stocks can be risky because the lack of trading volume makes it difficult to move in or out of a position at a reasonable price.
1Investing involves risk, including the possible loss of principal. Preferred stock is subject to many of the risks associated with debt securities, including interest rate risk. In addition, preferred stock may not pay a dividend, an issuer may suspend payment of dividends on preferred stock at any time, and in certain situations an issuer may call or redeem its preferred stock or convert it to common stock. High-yielding stocks are often speculative, high-risk investments. These companies may be paying out more than they can support and may reduce their dividends or stop paying dividends at any time.
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