Understanding Preferred Stock

What is Preferred Stock, and does it belong in My Portfolio?

Understanding Preferred Stock
April 25, 2014

"Preferred stock" is a misnomer in several ways. It is as much like a bond as a stock, and many preferred aspects are from the company's point of view instead of investors.

Like a bond, preferred stock is issued with an annual dividend and preset share price, typically $25 per share. In another similarity to bonds, the beginning yield (dividend divided by price) is known as the coupon rate. The coupon rate varies with typical supply and demand market volatility.

Some properties of preferred stock are listed below – note that some do not apply to all preferred stock:

  • Dividends – While common stock dividends may fluctuate, preferred stock provides a steady dividend (assuming any dividends are paid at all – see “Accumulation" below). Yields are generally in the range of 4-8%, paid out quarterly.

    Dividends must be paid to preferred stocks before common stocks, but preferred stocks do not receive higher dividends in better times.

  • Taxes –"Qualified" dividends are taxed at the capital gains rate; otherwise, they are taxed as income. To be qualified, the underlying stock for the dividend must meet various requirements regarding the issuing company, IRS classification, and your holding time.

  • Maturity – A preferred stock may have a maturity date, but most are perpetual. However, they are often limited because of the issuing company's ability to call (see "Callable" below).

  • Callability – Like a bond, most preferred stock is callable, typically any time after five years and usually at par value (value at issue). Generally, stock is called in when interest rates rise, to be replaced with new issues.

  • Accumulation – With a cumulative preferred stock, deferred company dividends accumulate over time, and all preferred shareholders must be paid before holders of common stock.

  • Convertibility – With convertible preferred stock, the stock can be converted to common stock at some future date. This is a one-way transfer, typically as a percentage or fixed dollar amount instead of a set number of common shares.

  • Participating – In a participating common stock, preferred stockholders may also participate in extra dividends, such as bonuses for meeting a financial goal, over and above the fixed dividend.

  • Rights – Preferred stockholders do not have voting rights, but they do have an earlier claim on assets. As a holder of preferred stock, you have an advantage over common stock holders if a company goes bankrupt.

Unfortunately, debt holders are paid before shareholders in bankruptcy, and there generally is nothing left by the time any shareholders get involved. After all, if the company had that much money available, they probably would not be going bankrupt in the first place.

Preferred stocks are not often highly rated or rated at all. Companies have to pay to have stocks rated, and they usually don't bother doing so with preferred stock. Thus, preferred stock represents un-assessed risk.

Does preferred stock have a place in your portfolio? It potentially could. Preferred stocks fill a gap in portfolios between riskier stocks and conservative bonds. They have a superior yield to bonds, but they have maturity risk due the unpredictability of a call. The risk is not symmetric like it is with non-callable bonds, since the issuing company can call in the bonds anytime when interest rates are favorable to them, but you do not have the ability to make the issuer take the stock back when prices are favorable for you.

You also have to ask yourself why a company is issuing preferred stock instead of common stock. Interest on preferred stock is taxable to the company while bonds are not. The main advantage is the callable option – meaning the company intends to call when it is to their advantage. Moreover, you are not guaranteed the par price (face value) as you are with bonds.

If you are in a market where the yield on preferred stocks is significantly above bonds, they are an attractive option – otherwise, bonds may make more sense due to relative security and symmetric risk. In any case, it is probably best to diversify risk within preferred stocks by finding a preferred stock fund, unless you feel strongly about one particular company.

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