Yahoo Finance Are Preferred Stocks Preferable?
Breed a Labrador retriever with a toy poodle and you get a Labradoodle. The best of both, admirers say. Blend a stock and a bond and you wind up with a preferred stock, the darling of many fixed-income investors.
Like a bond, a preferred stock pays fixed, predictable interest, but in the form of a dividend, like a stock. If things go wrong, the preferred stockholder ranks ahead of the common stockholder for receiving dividends and any distribution of company assets in a liquidation. But preferred shareholders must wait in line behind bondholders.
Most important, preferreds often offer higher yields than either stocks or bonds. These days many preferreds yield upwards of 5, 6, or even 7 percent. The iShares US Preferred Stock exchange-traded fund (PFF), which tracks an industry benchmark, the Standard & Poor's U.S. Preferred Stock index, yields a handsome 5.74 percent.
[See: 9 Ways to Pile Into High Yield With Preferred Stocks.]
"They tend to be the most popular with retirees who are having trouble making their cash flow," says Scott Stratton, president of Good Life Wealth Management in Dallas.
"The dividends are typically higher than corporate bonds and as such (preferreds are) considered less risky," says Dan Eyman, managing director at San Francisco-based Meld Valuation, a firm that serves startups that issue preferred stock.
Unlike most bonds, many preferred stocks do not have a firm maturity date or price, so investors don't know exactly when they'll recover their principal. That requires selling amid changing market conditions, like selling bond at a market price before it matures.
However, preferred stocks can be called like many bonds, generally at a par value set when the shares are issued. That happens when interest rates fall and the issuer no longer wants to pay those generous yields. Often, a company will buy back its preferred stock with money raised some other way, just as a homeowner will pay off a high-rate mortgage with a cheaper one.
In many cases, issuers can convert preferreds to common shares or have their fixed rates changed to floating ones. Dividend payments can be suspended in hard times, but the company generally must make up the missed payments before paying dividends on its common stock.
Cara Esser, a fund strategist at Morningstar, notes in an analysis of preferred stock prospects that a call can have a double whammy.
"Should a firm call a security early, the redemption price is par," she writes. "This means investors not only lose high-coupon payments but incur a loss of principal for any security purchased above par."
As with bonds, the investor receiving a lump sum in a preferred stock call will likely have to reinvest at a lower yield.
Also, preferred share prices fall like bond prices do when interest rates rise, because investors don't want the older, stingier shares.
"They tend to behave like long-term bonds," because they have no fixed maturity date, Stratton says. "The longer a bond is the more its price is going to move because of interest rate (changes)."
Since rates are at record lows and more likely to rise than fall, preferreds look particularly risky today, he adds.
"Today I'm pretty cautious on them because the prices are quite high," Stratton says. "I'm concerned about the interest-rate volatility that we face."
Like all stocks, preferred prices can fall if the firm falters, since there's a risk interest will not be paid. But preferred prices generally don't rise when earnings do, since these stocks behave more like debt than equity, so investors don't typically enjoy large capital gains.
Preferreds generally are not as volatile as common stocks, and their owners have no voting rights.
[See: 10 Questions to Ask Before You Hire a Financial Advisor.]
When a preferred stock sells at a premium well above its original par value, the fixed coupon, or interest payment, falls as a percentage of the stock's price. Stratton says a preferred stock with a 6 or 7 percent coupon may actually yield only 5 percent due to the price premium. If the stock can be called soon, the yield relative to the call date and price may be only 1 or 2 percent despite a 7 percent coupon, he says.
A few years ago many preferreds were selling at a discount, so that a 7 percent coupon meant a real yield of 10 percent, Stratton says.
"I prefer to buy at a discount," he says, adding that "it's impossible to do today" because investors hunting high yields have bid up prices
Financial institutions, real estate investment trusts and utilities are the biggest issuers of preferred stock, so investors must decide how much exposure they want to those sectors, he says.
"If you buy individual preferred stock, this can lead to inadvertently concentrating your portfolio in specific financial firms as well as in the financial sector as a whole," Eyman says.
As with all dividend-paying stocks, an unusually high yield can spell trouble, such as a falling share price that makes the past year's dividend payments look very generous. A dividend cancellation could follow, or a continued plunge in share prices could offset your dividend earnings.
Stratton says investors who choose individual preferreds need to study the terms in the prospectus closely for features like when the stock can be called or converted to common stock, and at what price, or when dividend payments can be changed.
Also important is the company's credit rating, says Collin Martin, senior fixed income research analyst at the Schwab Center for Financial Research.
"These securities can carry either investment-grade or sub-investment-grade ratings," Martin writes in an assessment of pros and cons. "But we prefer preferred securities with investment-grade ratings, which tend to offer higher yields than other comparable investment-grade fixed income assets."
Over the years, says Esser, credit risk has become a bigger concern for preferred stock investors.
There's also a tax issue. Preferred dividends are often taxed at the same 15 percent rate that applies to common stock dividends, which is better than the higher income tax rates on bond earnings. But that's not always the case, so it's important to investigate before buying.
[Read: 5 Reasons You're Bad at Investing.]
The alternative is to leave the choosing to the pros by using a mutual fund or ETF. While that is an index-style fund that tracks the entire sector, there are also some actively managed funds that look for the best deals.
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