Investing In Preferred Stocks

by Russ Allen, Online Trading Academy Instructor

Online Trading Academy Article of the Week

We’ve written a few times before about U.S. preferred stocks. These are different from the stocks that make up what we usually think of as the ‘stock market’. The stock market is made up of ‘common stocks’. Each of the two kinds of stocks has its place, and you might very well want to invest some money in both. With common stocks near all-time highs, it is important to consider investment alternatives, as you may not want to commit more money to the stock market at these nosebleed levels.

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The ‘preferred’ in ‘preferred stock’ refers to the fact that preferred shareholders have certain rights to the company’s assets, and these obligations must be satisfied before the common shareholders can receive any money.

Preferred shares (or ‘preferreds’) are a sort of hybrid between common stocks and bonds. Like common stocks, they are an equity stake in the company. Preferred shareholders are part owners of the company – they are not creditors, as bondholders are. But preferreds are like bonds in other ways. They do have a set face amount, which is called the issue price, call price or liquidation preference. They also have a fixed payment rate, like a bond’s interest rate. In the case of preferreds, this fixed payment is not called interest, it is called a dividend. The rate that a preferred stock pays in dividends is usually part of the name of the preferred stock. For example: DDR Corp 6.375% Class A.

This is a preferred stock issued by DDR Corp. The company pays dividends on this stock at the rate of 6.375% of the face value per year. ‘Class A’ refers to the fact that a company may have issued several different series of preferred stocks over the years, with different dividend rates. There might be a Class B, Class C, etc. This is not a recommendation, just an example.

There are a few things about preferred stocks that might make them attractive to you:

• They always pay substantial dividends, that are higher than the interest the same company would pay on its bonds, and usually higher than the dividend yield on its common stock.
• They are higher in the capital structure than common stocks, so in case of trouble they are safer than common stock (although they could still become worthless if the company were to go bankrupt, if there was no money left after paying creditors and bondholders).
• Their prices are not nearly as volatile as common stocks.
• The dividend income may be a ‘qualified’ dividend for tax purposes. If so, in the U.S. the preferred dividends are taxed at long-term capital gains rates of 15% or 20%, rather than at full ordinary income tax rates of up to 37% as bond interest or bank interest would be.
• Because their face amount is small (almost always $25 per share), it is easy to create a diversified portfolio of preferred stocks from several different issuers, even with a small portfolio.

The high cash flow returns from preferred stocks do come with some downsides – there is a reason their yields are always higher than that of the same company’s bonds or common stocks:

• A preferred share is a right to a fixed number of dollars of the company’s equity, not a percentage of its equity like common stock. The price of the company’s common stock can go up over time as the company’s net worth grows. Preferred stock prices do not go up in this way, no matter how successful the company is. You own them purely for the cash flow, not for any hope of appreciation.
• Preferred stock dividends can be suspended if the company’s cash flow doesn’t support them. Bond interest payments cannot. It is easy to check whether a company has ever missed any preferred dividend payments. Many companies have never missed a payment in decades, but we do need to do our homework.

If you would like to have some money in an investment that is more secure than common stock and pays better dividends. and has a higher return than the interest on cash or bonds, consider preferred stocks.

To summarize what we have covered up to this point:

As a conservative income-generating instrument, preferred stocks have a lot to offer. Their reason for being is to pay dividends. Dividend yields for investment-grade preferred stocks are now often in the mid 6 to over 8%, and sometimes even higher. On lower-rated preferreds, yields are higher still. Preferred stock prices are much less volatile than common stock prices, though they do fluctuate more than bond prices. And some preferred shares have preferential tax treatment.

The preferred stock world is pretty diverse – at last count, almost 500 different preferred stocks were available, issued by all kinds of companies. The biggest issuers of preferred stock are banks; REITs and utilities are also big users. There are quite a few web sites that are dedicated to preferred stocks, so research is not hard to do.

For individual investors interested in preferred stocks, a few selection criteria can help you narrow down the list of candidates:

1. Credit rating.

Many issuers of preferred shares have credit ratings assigned by the same rating agencies that rate bonds – Moody’s and Standard and Poor’s. A Standard & Poor’s ratings of BBB- or better, or a Moody’s rating of Baa3 or higher are considered Investment Grade, meaning there is a low risk of default. Below are the rating scales:

Interestingly, not all preferred stock issuers have their shares rated. Less than half have any ratings at all. Banks, which are the largest issuers of preferred stock, almost never submit their preferred shares for ratings. Not having a credit rating doesn’t necessarily mean that the preferred stock is a bad risk – but it does mean that you have no way of knowing. If you are concerned about the safety of your investment, sticking to preferred shares rated investment grade is a good place to start.

2. Cumulative Dividends

Some preferred stock shares are cumulative – meaning that if the issuer misses a dividend because of insufficient cash flow, they must make it up later. However, not all issues are cumulative – only about two out of three. During the 2008 financial crisis, many banks suspended their dividends for many months and were not required to make them up.

Taken together, narrowing down the entire preferred stock universe to those issues that are both investment grade and cumulative cuts down the population to under 180 issues – a manageable number to evaluate.

3. Liquidity

Liquidity of the preferred shares can be an issue. Because preferred shares are more thinly traded than common shares, the spread between the Bid and Ask prices can be large. For individual investors, who generally buy at the Ask price and eventually sell at the Bid price, the bid-ask spread is a cost of owning the shares. Even though you may have no intention of selling the preferred shares you buy today any time soon, you will eventually incur the spread. It is not uncommon for the spread to exceed a year’s worth of dividend income. A precious few preferred issues have bid-ask spreads of less than two quarters’ worth of dividends. It is easy to observe the bid-ask spread of any preferred issue you are thinking of buying within your online trading platform.

4. Qualified or non-qualified dividends

For investors who plan to hold preferred shares in a taxable (non-IRA) account, the qualified nature of many preferred stock dividends is important. For those preferreds whose dividends are qualified (which are most preferreds issued by companies other than REITS), the dividends are taxed at the investor’s long-term capital gains tax rate, rather than their ordinary income tax rate as bond interest income would be.

Filtering preferred stock shares by all of these criteria: credit ratings. cumulative vs non-cumulative, liquidity and qualification of the dividends, will narrow down your search to a handful of candidates. Choose them well, and preferred shares can reward you with years of stable income at high rates.

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