Dave Dyer

Higher yields and lower risks…what’s not to like? Why is this intriguing investment class often ignored by investors?

The “preferred” in preferred stocks means that the holders of preferred stocks get preferential treatment, in comparison to the holders of common stock, if there is a bankruptcy. The bond holders get paid first, then the holders of preferred shares, and, if there is any money left over, the holders of common stock get some. Bankruptcies are not common, especially in the kind of well-funded public companies that make good investments, but if one does happen (say, Continental Airlines) you would rather own the preferred than the common.

In exchange for this extra safety, the owners of preferred stocks have to put up with higher yields. Huh? Yes, the yields on preferred stocks are usually 6% or more, often double the yield, if any, on the common stock of the same company. For example, the Bank of America common has a yield of 1.2%, but its safer preferred yields 6.3%. You must have to give up something in order to get this good deal, or is Mother Theresa in charge of issuing all preferred stock?

Well, the holders of preferred stock do not get to vote. For almost all individual investors, this is not a big deal. Few of them have ever taken the time to vote, anyway.
Preferreds are often described as a hybrid between a bond and a stock. Like a stock, you get equity in the company, and like a bond you get higher yields at a fixed rate. This should be a good fit for income-oriented investors who are more likely to be interested in the yield aspect than in the chance for capital appreciation. Preferreds are often called boring, but in times of low returns and high volatility, boring may be exactly what people need.

Preferreds are almost all issued at a par value of $25 per share and they are callable by the issuer at $25 according to the specific terms for each class of preferreds. They will often have call protection for a few years, a feature that makes them easier to sell. Some are also convertible into common shares of the company. The specific details of each class of preferreds differ, and it can be a bit daunting to understand the specific terms of each one. Also, companies will often have multiple classes of preferreds, and each may have unique terms. However, this complexity may be an advantage to individual income-oriented investors because preferreds are not a favorite of day traders. Because there are fewer short-term holders, there should be less volatility. And income investors don’t like volatility

The $25 par value provides a convenient way to assess your risk. If you pay $26 a share, you know that you can only lose $1 if it is called. Of course, there is no assurance that a stock will be called when there is no call protection. That is up to the issuer and they may keep it out there for years. Especially in times when interest rates are stable or rising, they may not want to replace it with a new issue at higher rates. There is more motivation to call them when they can be replaced with a class of preferreds that pays a lower yield.

There is a tax rule in the preferred world that adds stability and reduces volatility. Corporate owners of preferred shares get some tax advantages because 70% of the income is exempt from corporate taxes. We all know how this probably happened; someone had a good lobbyist who got something into a tax bill that was never read by the legislators who voted on it. And they probably would not have understood it even if they did read it. The end result is that corporations are encouraged to own preferred shares of other companies. Corporations are normally long-term holders, not day traders, and this stability in the ownership base results in lower volatility, an advantage for individuals.

For individuals, the income from preferreds can count as qualified dividends for tax purposes, but the rules are a bit complex. Please read IRS Publication 550 for the details.

Why would a company issue preferreds rather than more stock or more bonds? Considering preferreds from the standpoint of the issuer can help the individual investor understand them.

1. There is no dilution of the value of the common stock when preferreds are issued. Since executive compensation is often tied to the price of the common stock, I think we can see who might want to see preferreds rather than more common stock.

2. The lack of voting rights with preferreds could be an advantage if the issuer is worried about the possibility of a hostile takeover.

3. Preferreds are not considered when calculating the debt ratios that many companies manage closely. A company at the upper range of its allowable debt may benefit from issuing preferreds even if they have to pay higher rates.

4. Preferreds are often a good way to finance short-term projects without incurring long-term debt.

But it is more important to think about preferred stocks from the position of the individual investor, your point of view. You get higher yields than dividend paying stocks and with less volatility. And you get yields as high as junk bonds with less risk. Of course, you are not likely to get much capital appreciation, but that should not be a big problem if you plan to use preferreds as part of an income strategy.

Another potential concern is that preferred stocks will show some decline in value if interest rates increase. Of course, most other income investments face this same problem. However, if the yield on 10-year treasuries goes to 3% most investors would probably rather be stuck holding a 7% preferred than a 2% government bond.

Investors in preferreds should also be aware that it is possible for an issuer to miss a dividend payment. This is an uncommon event and would only happen if a company was in serious financial trouble. Many preferreds are classified as cumulative which means that missed payments must be made up. Others are non-cumulative and missed payments are no longer due once they are missed. Obviously, the cumulative ones are more desirable. However, in both cases the preferred payment can only be missed if the company has already failed to pay the dividend on the common shares.
How can an individual investor invest in preferred stocks?

Preferred stocks are traded on the major exchanges just like common stocks. They normally have small market caps and trade in low volumes. However, it is best to get advice from your financial advisor to help you select the best ones for you. There can be wide variability between various preferreds, even ones from the same company, on issues like maturity, convertibility, call features, payment deferrals, and yields An advisor can help you understand the factors that are unique to the world of preferred stocks. You will also want to understand the financial strength of the issuing company just as you would if you bought the common stock of that same company.