Preferred Stocks: Are They for You?
Don’t be fooled by their name. “Preferred” stocks are not the creme de la creme of stocks, and most investors don’t necessarily prefer them. But they do offer some value and may be worth looking into, especially if your goal is higher dividends. Caution is advised, however.
These days, due to low interest rates on government and high-quality corporate debt, many investors are indeed looking for higher yielding forms of fixed income. “Preferred” stock is one of them. It is actually a hybrid equity-bond investment. The stocks are purchased like common stocks but have lower volatility in general than common stocks. Dividends, which typically are paid quarterly, range from 4% to 8% and sometimes 10%.
That’s the good news. There are also potential risks and downsides. The issuing company may not be strong and potentially facing financial problems. If you look at their financials, you might see that they’ve already loaded their balance sheet with a large amount of debt and risk a downgrade if they add even more. Alternatively, they might be issuing the preferred stock for regulatory reasons.
Moreover, unlike with common stocks, in which investors can benefit from growth in the value of the company, the return on preferred stocks is simply a function of the dividend yield. While common stocks may soar on good company news, not so the preferreds.
While preferred stocks are purchased in much the same way as common stock, you should research them well and understand their basic characteristics before purchasing them. Preferred stocks have many variables. Here are just a few.
Are the shares voting or nonvoting? Most preferred stocks do not give owners voting rights. If dividends have not been paid for a certain length of time, however, some companies will give voting rights to shareholders.
Are the shares cumulative or noncumulative? Cumulative means that the dividends will accrue even if they are not paid quarterly.
Are they convertible? Convertible preferred stocks can be turned into a certain number of shares of the company’s common stock after a predetermined time span or on a specific date. The investor is getting both a fixed-income component with a steady income stream and some protection of his/her capital. If they are convertible, the investor can convert them to gain from a rise in the share price.
Are the preferred shares fixed rate or adjustable? If they are adjustable, you will not be able to count on a specific dividend.
Additionally, even though preferred stock shareholders receive preference over common stock shareholders, if there is a bankruptcy, preferred shareholders will be paid before common shareholders but after creditors and bondholders.
Preferreds can be volatile. While they are not as price sensitive as bonds when interest rates fluctuate, their prices are affected by general market factors to a greater degree than bonds. And, since preferred stocks are either perpetual (have no maturity) or are generally long term, typically with a maturity of between 30 and 50 years, if interest rates decline, the company that issued the preferred stock may buy back the shares to issue new ones at a lower rate. And vice versa; if rates go up, the investor may then be left holding a security that pays less than the market rate for many years.
The very long-term maturity of preferred stocks also can be problematic. Historically, longer maturities have the poorest risk/reward characteristicsÑthe lowest return for a given level of risk. The long maturity typical of preferred stocks isn’t the only problem with these securities. They typically also carry a call provision. This means if rates rise, the price of the stock will likely fall. And, if rates fall, the company that issued the preferreds will likely exercise their call option and replace it with a lower rate issue, or even common stock.
Be sure to consult your financial adviser and go over every aspect of preferred stocks in relation to your financial goals and risk tolerance.
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