by Russ Allen, Online Trading Academy Instructor
Online Trading Academy Article of the Week
In our ProActive Investor program, we educate investors to enable them to manage their investments to best meet their individual objectives. With some knowledge of how the investment world works, investors can guide their financial advisers – or possibly eliminate them. The fact is, no one cares as much about your financial future as you do.
To navigate the investment ocean, one of the first requirements is to know the choices that are available to an individual investor.
We have written before about several investment vehicles and the related strategies that can provide solid returns. One that we have not yet covered is investing in preferred stocks for dividend income.
Preferred stocks, as the name implies, are different from common stocks. First, they almost always pay significant dividends – from an investor’s point of view, that is the point of owning the preferred stock. Currently, many solid preferred stocks are paying dividends in the 6% range or higher.
Preferred stocks have preferential treatment in the case of a liquidation of the company, in a bankruptcy or otherwise. In general, the preferred shareholders must be paid the full par value of their shares before any money is paid to common shareholders. So, preferred shareholders are in line to be paid ahead of common stockholders (but not ahead of bond holders or secured creditors).
Preferred stocks (or “preferreds”) are a sort of hybrid between stocks and bonds. They pay a fixed annual payment, like a bond’s coupon rate. They may have a redemption date, which is similar to a bond’s maturity date. On the redemption date, if there is one, the par value (which is also confusingly called the “liquidation preference”) will be repaid in cash to the preferred shareholders. It should be noted that since preferred shares pay a fixed annual amount, in times of rising interest rates the prices of preferred stocks will drop as bond prices do. How much they drop depends on how distant their redemption date is. The further out it is, the greater the impact of the rate change, with those that are perpetual (no redemption date) showing the biggest impact.
Although preferreds share several characteristics with bonds, they are in fact a type of ownership interest, not a debt interest. The issuing company does have the right not to pay preferred dividends because of a lack of available cash. Failure to pay the dividends will not be considered a default event, as would be the failure to pay interest on bonds. Many preferreds are cumulative, which means that any missed dividends are accrued and must be paid when cash flow allows and before any payments to common stockholders. There are numerous preferred stocks that have been in existence for years or decades without a single missed dividend, and this can easily be checked.
Because of their status as an ownership interest and not a debt interest, preferred stocks tend to fluctuate in price more than bonds do. This can also be checked easily by referring to a preferred stock’s price chart. If your plan is to hold the preferred stock for the long term to collect the dividends, moderate price fluctuations are not necessarily worrisome if the dividend history is solid. But if you did need to liquidate preferred shares there is a chance that there would be a capital loss.
One of the things that can make preferred stocks – well, preferred to bonds as a steady cash flow generator is that the investments in them can be in small amounts. Many preferred shares trade in the range of $25 per share. Bonds by contrast usually trade in minimum denominations of $1000, and often an investor must buy a minimum number of three, five, ten or more, not just one bond at a time. For smaller nest eggs, it is hard to build a diversified portfolio of several bond investments when each one costs several thousand dollars. It’s quite easy with preferred stocks to allocate as little as a few hundred dollars each among several different issues.
Another advantage of preferreds as compared to bonds is in the tax treatment of the cash flow derived from them. Some (but not all) preferred dividends are “qualified” dividends for tax purposes. This means that the dividends are taxed at a rate of 15% or 20% depending on the investor’s tax bracket. This is compared to the ordinary income tax rates of up to 39.6% that apply to the interest income on bonds (other than municipal bonds).
For high yields, steady income, flexibility and tax efficiency, preferred stocks can be a winning solution for many investors.
