How to Invest in Preferred Stocks

Investing in preferred stocks can be an attractive option for individuals seeking to diversify their portfolios and earn a steady income stream. As a hybrid between stocks and bonds, preferred stocks combine features of both equity and debt securities. These instruments offer unique benefits, such as higher dividends than common stocks and priority over common stockholders in the event of liquidation. However, they also come with specific risks and considerations that every investor should understand before jumping into the market.

In this article, we will explore the concept of preferred stocks, the advantages and disadvantages of investing in them, how to evaluate and select preferred stocks, and the factors that affect their value. By the end of this guide, you should have a solid understanding of how to approach preferred stock investments strategically.

What Are Preferred Stocks?

Preferred stocks are a type of equity security that represents ownership in a company but with certain preferential treatment over common stockholders. Unlike common stocks, preferred stocks do not offer voting rights, but they do provide the holder with a fixed dividend payment, which is typically higher than what is offered to common stockholders.

Preferred stocks are called "preferred" because they have a higher claim on the company's assets and earnings. This means that, in the event of liquidation, preferred stockholders are paid before common stockholders. However, they are still behind bondholders in the hierarchy.

Key Features of Preferred Stocks

• Fixed Dividends: Preferred stocks typically offer a fixed dividend that must be paid before any dividends are distributed to common stockholders.
• Priority in Liquidation: In case of liquidation, preferred stockholders are paid after bondholders but before common stockholders.
• Convertible or Non-Convertible: Some preferred stocks can be converted into common shares under specific conditions, offering the potential for capital appreciation.
• Callable or Non-Callable: Some preferred stocks can be called (redeemed) by the issuing company before their maturity date, typically at a premium.
• Cumulative vs. Non-Cumulative Dividends: Cumulative preferred stock means that if a company skips a dividend payment, it must make up for it in the future. Non-cumulative preferred stocks do not have this provision.

Advantages of Investing in Preferred Stocks

Preferred stocks can be an attractive investment choice for several reasons, particularly for income-focused investors. Below are some key benefits of investing in preferred stocks.

1. Stable Income Stream

The most significant advantage of preferred stocks is the predictable and stable income they provide. The fixed dividends offered by preferred stocks can be appealing to investors seeking regular income, such as retirees or income-focused investors. The dividends are typically paid quarterly, providing a reliable cash flow stream.

2. Priority Over Common Stocks in Liquidation

In the event that a company goes bankrupt and is liquidated, preferred stockholders are entitled to be paid before common stockholders, although they are still behind bondholders. This priority in liquidation can offer some protection to investors compared to owning common stock.

3. Less Volatility than Common Stocks

Preferred stocks tend to be less volatile than common stocks because of their fixed dividend payments and higher priority in liquidation. While the value of common stocks can fluctuate dramatically with market conditions, preferred stocks generally provide a more stable price performance, particularly in stable or low-interest-rate environments.

4. Potential for Price Appreciation

While preferred stocks are primarily valued for their dividend income, some preferred stocks also offer the potential for price appreciation, especially if they are convertible into common shares. This could be a potential upside if the company performs well and the value of its common stock increases.

5. Tax Advantages

In some cases, dividends from preferred stocks can be more tax-efficient than bond interest. In the U.S., for example, qualified dividends are taxed at a lower rate than ordinary income. However, this can vary depending on the investor's tax bracket and the type of preferred stock.

Disadvantages of Investing in Preferred Stocks

While preferred stocks have several advantages, they are not without their drawbacks. Investors should carefully weigh these potential disadvantages before deciding to invest in preferred stocks.

1. Limited Capital Appreciation

Preferred stocks typically do not experience the same level of capital appreciation as common stocks. They are primarily income-generating investments rather than growth-oriented investments. This means that if you're looking for significant capital gains, preferred stocks may not be the best choice.

2. Interest Rate Sensitivity

Preferred stocks are sensitive to changes in interest rates. When interest rates rise, the value of preferred stocks tends to fall, as investors may seek higher returns elsewhere. Conversely, when interest rates fall, preferred stocks become more attractive, and their prices may increase. However, this sensitivity can result in price fluctuations, especially in a rising interest rate environment.

3. No Voting Rights

Preferred stockholders do not have voting rights in the company, unlike common stockholders. This means that they have no influence over the company's decision-making process, such as the election of board members or important corporate decisions. For investors who want to have a say in how a company is run, this can be a significant drawback.

4. Potential for Callable Stocks

Some preferred stocks are callable, meaning the issuing company can buy back the stock at a predetermined price, typically above the original issue price. While this can be beneficial to the company, it can be a disadvantage to the investor, as they may be forced to sell the stock at an unfavorable price if interest rates fall and the company decides to redeem the stock.

5. Dividend Payment Risk

While preferred stocks typically provide a fixed dividend, there is no guarantee that these dividends will always be paid. In times of financial distress, companies may choose to suspend or reduce dividend payments to preserve cash. This risk is particularly relevant for non-cumulative preferred stocks, which do not require the company to make up for missed dividends.

How to Evaluate Preferred Stocks

Evaluating preferred stocks requires a different approach compared to common stocks or bonds. Below are some key factors to consider when assessing preferred stocks for investment.

1. Dividend Yield

The dividend yield is one of the primary factors to consider when evaluating preferred stocks. The yield is calculated by dividing the annual dividend by the stock's current market price. A higher dividend yield can be appealing to income-seeking investors, but it's important to ensure that the company can sustain the dividend payment.

2. Credit Rating

The credit rating of the issuing company plays a crucial role in assessing the safety of preferred stock investments. Companies with high credit ratings are less likely to default on their dividend payments. Conversely, companies with lower credit ratings may face higher risks of financial difficulties, which could lead to dividend cuts or suspension.

3. Interest Rate Environment

As mentioned earlier, preferred stocks are sensitive to changes in interest rates. It's important to consider the current and projected interest rate environment when evaluating preferred stocks. In a rising interest rate environment, the value of preferred stocks may decrease, while in a falling interest rate environment, preferred stocks may become more attractive.

4. Callability

Check whether the preferred stock is callable. If it is, determine the call date and the price at which the company can redeem the stock. Callable preferred stocks can limit the investor's upside potential if the company decides to redeem the stock early, particularly if interest rates decline.

5. Company Fundamentals

As with any investment, it's important to assess the underlying company's financial health. This includes reviewing the company's balance sheet, income statement, cash flow, and overall business strategy. A company with strong fundamentals is more likely to continue paying dividends on its preferred stock.

6. Cumulative vs. Non-Cumulative Dividends

Investors should also pay attention to whether the preferred stock is cumulative or non-cumulative. Cumulative preferred stocks are generally safer, as any missed dividends must be paid in the future. Non-cumulative preferred stocks, on the other hand, do not offer this protection, and missed dividends are lost.

How to Buy Preferred Stocks

Investing in preferred stocks is similar to investing in common stocks, but there are a few differences to be aware of. Here are the basic steps to purchase preferred stocks:

1. Choose a Broker

To invest in preferred stocks, you will need to open a brokerage account. Most online brokers offer access to preferred stock markets, so you can easily purchase preferred stocks from major exchanges like the NYSE or NASDAQ.

2. Research Preferred Stocks

Before purchasing preferred stocks, take the time to research individual stocks. Focus on factors such as the dividend yield, credit rating, callability, and the issuing company's financial health.

3. Place an Order

Once you've chosen the preferred stocks you want to invest in, place an order through your broker. You can typically choose between a market order (buying at the current market price) or a limit order (setting a specific price at which you want to buy the stock).

4. Monitor Your Investments

After purchasing preferred stocks, regularly monitor their performance. Pay attention to changes in the company's financial situation, any changes in interest rates, and any announcements regarding dividends or calls.

Conclusion

Investing in preferred stocks can be an excellent way to generate stable income while diversifying your portfolio. These hybrid securities offer the potential for higher dividends than common stocks, as well as priority in liquidation, making them appealing to conservative investors. However, preferred stocks also come with certain risks, such as limited capital appreciation and interest rate sensitivity, that must be carefully considered.

By understanding the unique characteristics of preferred stocks and evaluating key factors like dividend yield, credit ratings, and the interest rate environment, investors can make informed decisions and build a balanced investment strategy. While preferred stocks may not be suitable for every investor, they can be a valuable addition to a well-diversified portfolio, particularly for those seeking income stability and lower volatility.

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