How to Understand Preferred Stocks

Preferred stocks are a unique and often misunderstood asset class in the world of investing. While common stocks receive most of the attention in the media and among retail investors, preferred stocks occupy an important space in the investment landscape, particularly for income-seeking investors or those looking for stability within the equity market. Despite their name, preferred stocks do not always function in the same manner as common stocks. Understanding their structure, characteristics, and potential risks and rewards is essential for anyone looking to incorporate them into their portfolio.

This article will delve into the key features of preferred stocks, their benefits and risks, how they compare to common stocks and bonds, and the different types of preferred stock available. By the end of this guide, you will have a comprehensive understanding of preferred stocks and how to use them as part of a diversified investment strategy.

What Are Preferred Stocks?

Preferred stock is a class of ownership in a corporation that ranks above common stock but below bonds in terms of claim on assets and earnings. The main characteristic of preferred stock is that it provides investors with fixed dividends, typically at a higher rate than common stock dividends. In the event of liquidation, preferred stockholders are paid before common stockholders, but after bondholders.

Preferred stock is sometimes referred to as a hybrid security because it combines features of both equities (common stock) and debt (bonds). Like common stock, preferred stock represents ownership in a company, but it behaves more like a bond in that it provides a fixed income stream (through dividends) and has a priority claim on assets in the event of bankruptcy.

1.1 The Structure of Preferred Stocks

• Dividend Payments: One of the most attractive features of preferred stocks is the predictable dividend payments. Preferred shareholders are usually paid a fixed dividend, which is paid before common stock dividends. This provides an element of stability for investors, as they can rely on these payments, especially in a low-interest-rate environment.
• Claim on Assets: In the event of liquidation or bankruptcy, preferred shareholders have a higher claim on the company's assets than common shareholders but are subordinate to debt holders. This means that if a company goes bankrupt, bondholders will be paid first, followed by preferred shareholders, and any remaining assets will go to common shareholders.
• Cumulative vs. Non-Cumulative: Some preferred stocks are cumulative, meaning that if the company misses a dividend payment, the unpaid dividends accumulate and must be paid to preferred shareholders before any dividends can be paid to common stockholders. Non-cumulative preferred stocks, on the other hand, do not accumulate unpaid dividends, so if a company skips a payment, the shareholder does not have the right to claim it later.
• Convertible Preferred Stock: Some preferred stocks have a conversion feature, allowing the shareholder to convert their preferred shares into a fixed number of common shares. This can provide additional upside potential if the company performs well.
• Callable Preferred Stock: A callable preferred stock can be redeemed by the issuing company after a certain period at a predetermined price. This provides flexibility to the company but introduces reinvestment risk for the investor.

Benefits of Preferred Stocks

While preferred stocks are often considered a more conservative investment compared to common stocks, they offer several key advantages that can make them an attractive option for certain investors.

2.1 Steady Income Stream

One of the main reasons investors are drawn to preferred stocks is the predictable income they offer. Preferred stocks generally pay a fixed dividend that is higher than the dividends of common stocks and more stable. For income-seeking investors, this can be particularly appealing, especially in a low-interest-rate environment when bond yields may not provide sufficient returns.

2.2 Priority Over Common Stock in Dividends and Liquidation

As mentioned earlier, preferred shareholders are entitled to receive their dividends before common shareholders. In addition, if the company goes bankrupt and liquidates its assets, preferred stockholders have a higher claim on those assets than common stockholders. This makes preferred stock a safer investment than common stock in terms of both income and capital protection, though they are still riskier than bonds.

2.3 Potential for Capital Appreciation

While preferred stocks are typically considered income-generating investments, they can also provide capital appreciation under certain circumstances. If the company's performance improves, the price of its preferred stock can increase. Additionally, if the preferred stock is convertible into common stock, the investor can benefit from the potential upside of the common stock, which can rise in value over time.

2.4 Tax Advantages

In some cases, preferred stock dividends may receive preferential tax treatment. For example, dividends paid by U.S. corporations may be eligible for the qualified dividend tax rate, which is lower than ordinary income tax rates. This can make preferred stocks an attractive investment option for individuals looking to minimize their tax liability on dividend income.

Risks of Preferred Stocks

While preferred stocks have several benefits, they are not without risks. It's important to understand the potential downsides before investing in this asset class.

3.1 Interest Rate Sensitivity

Preferred stocks, like bonds, are sensitive to interest rate movements. When interest rates rise, the price of preferred stocks tends to fall, as their fixed dividends become less attractive compared to newly issued securities with higher yields. This means that investors holding preferred stocks may experience capital losses if interest rates rise significantly.

3.2 Credit Risk

Since preferred stockholders are subordinated to bondholders in the event of a bankruptcy, there is a risk that the company may not have sufficient assets to pay preferred dividends or redeem preferred shares. In this case, investors may lose some or all of their investment. While preferred stockholders have a higher claim on assets than common stockholders, they are still exposed to the company's credit risk.

3.3 Callable Feature

While the callable feature provides flexibility to the issuing company, it can be a disadvantage for investors. If interest rates decline, the company may choose to call (redeem) the preferred stock and issue new shares at a lower dividend rate. This can result in the investor losing their high-yielding investment and being forced to reinvest at lower rates, potentially leading to reinvestment risk.

3.4 Limited Upside Potential

Unlike common stocks, which can experience substantial capital gains when a company performs well, preferred stocks typically have limited upside potential. The price of a preferred stock is generally tied to the fixed dividend rate and the interest rate environment. Therefore, even if the underlying company performs exceptionally well, the price of preferred stock may not rise significantly.

3.5 Dividend Cuts or Deferrals

While preferred stock dividends are fixed, they are not guaranteed. A company may choose to defer or reduce its dividend payments on preferred stock, particularly during periods of financial hardship. In such cases, preferred shareholders may receive less income than expected, or even no income at all, if the company faces significant financial challenges.

Types of Preferred Stocks

There are several different types of preferred stocks, each with unique features and benefits. Understanding the differences between these types is crucial for investors who are considering adding preferred stocks to their portfolios.

4.1 Cumulative vs. Non-Cumulative Preferred Stocks

Cumulative preferred stocks require the company to make up for any missed dividend payments in the future. Non-cumulative preferred stocks, on the other hand, do not allow for missed payments to accumulate. Investors in cumulative preferred stocks have more protection in the event of dividend cuts, as the company must pay back any missed dividends before paying dividends to common shareholders.

4.2 Convertible Preferred Stocks

Convertible preferred stocks allow investors to convert their preferred shares into a predetermined number of common shares. This can be an attractive option if the company's stock price rises significantly, as it allows the investor to benefit from the potential upside of the common stock while still enjoying the fixed dividend payments of preferred stock.

4.3 Callable Preferred Stocks

Callable preferred stocks can be redeemed by the issuing company after a specified period at a predetermined price. This provides the company with flexibility, but it introduces reinvestment risk for the investor. If interest rates fall, the company may choose to call the preferred stock, forcing the investor to reinvest at lower rates.

4.4 Participating Preferred Stocks

Participating preferred stocks provide investors with the ability to receive additional dividends if the company performs well. In addition to the fixed dividend, participating preferred shareholders may receive a portion of any remaining profits after common stock dividends are paid. This can provide some upside potential for investors, especially if the company's profits grow significantly.

How to Invest in Preferred Stocks

Investing in preferred stocks can be done through several methods:

• Individual Preferred Stocks: Investors can buy individual preferred stocks issued by specific companies. This requires research and careful selection of companies with strong financial health and a track record of reliable dividend payments.
• Preferred Stock ETFs and Mutual Funds: For those looking for diversification and professional management, preferred stock exchange-traded funds (ETFs) and mutual funds are an attractive option. These funds pool investors' money to buy a diversified portfolio of preferred stocks, providing exposure to multiple companies and sectors.
• REITs (Real Estate Investment Trusts): Some REITs issue preferred stocks, which can provide investors with a steady income stream and exposure to the real estate sector.

Conclusion

Preferred stocks are a unique and versatile investment option that can be an excellent choice for income-seeking investors who want stability and a fixed income stream. They offer several advantages, including predictable dividend payments, priority over common stock in terms of dividends and liquidation, and potential for capital appreciation. However, they also come with risks, including interest rate sensitivity, credit risk, and the possibility of dividend cuts.

Before investing in preferred stocks, it is important to understand the different types of preferred shares, their associated risks, and how they fit within your broader investment strategy. By carefully considering these factors, investors can determine whether preferred stocks are an appropriate addition to their portfolios and how they can benefit from the income and stability they offer.

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