Preferred stocks can be attractive because of their high yields. For example, the average yield of preferred stocks followed by the “Preferred Stock Channel” was recently 6.46%. However, these yields come with significant risk compared to safe CDs. Unfortunately, CDs have much lower yields; for example, recently – with careful shopping – 5-year CDs were available with 1% yields and 1-year ones with .75%. Preferred stocks also pay substantially higher dividends than the S&P 500’s recent 1.7%.
Preferred stocks are hybrid securities. They are like common stocks because they pay dividends instead of interest and provide the holder with company ownership. They are like bonds because the dividends of most preferred stocks are fixed. Additionally, if the company enters bankruptcy, the preferred stockholder gets paid before the common stockholder. They also must receive their dividends before the common stockholder receives any. Real Estate Investment Trust preferred stocks have a further advantage. Since their common stocks must pay dividends if the company has taxable income, it’s very unlikely for a REIT preferred not to pay its dividend.
Some preferred stocks are “convertible.” This means they can be exchanged for common stock. This is good because the preferred stockholder can benefit from a rise in the common stock’s price. Many preferred stocks are “callable.” This means the company can force the preferred stockholder to sell the stock after a specified date at a predetermined price. This is bad because if interest rates fall making their fixed dividend worth more, the preferred stock is unlikely to rise in price due to the threat of the call. Some pay “cumulative” dividends. This means if a dividend is skipped, it must eventually be paid.
Some preferred stocks adjust their dividends periodically based on some index; for example, the 90-day U.S. Treasury bill rate. This provides protection against interest-rate increases. There are about 60 of these that trade on major exchanges.
Like bonds, preferred stocks are rated by Standard and Poor’s and Moody’s. Many are below investment-grade; that is, rated lower than BBB-. However, if bonds of the same company are investment-grade, it’s not critical.
Perhaps most significant is that unlike bonds, many preferred stocks are “perpetual;” that is, they have no maturity date when an investor knows that her investment will be returned. This means when interest rates rise, the fixed dividend will be worth less and the preferred stock’s price may fall.
The “ideal” preferred stock would be investment-grade, have a cumulative dividend significantly higher than alternatives like a 5-year CD or the S&P 500, or be indexed to interest-rates, have several years of call protection and sell below its call price. In the current historically low interest-rate environment with the FED indicating its intentions to keep it that way for years, investors should carefully balance the higher dividends of fixed-rate preferred stocks versus the potential for higher future dividends from an indexed preferred.
Investors considering a preferred stock should use a site like quantumonline.com to understand it. For investors who don’t want to buy individual preferred stocks there are mutual funds and ETFs.
All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at email@example.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.