Are Preferred Stocks a Good Investment?

Preferred stocks blend features of common stocks and corporate bonds, offering investors a distinct set of characteristics. They primarily focus on income generation rather than capital appreciation. Understanding their structure and operation within a company’s financial framework is key to evaluating their role in an investment portfolio. These securities appeal to investors seeking regular income streams with a specific risk-reward profile.

Understanding Preferred Stocks

Preferred stocks are hybrid securities, possessing attributes of both equity and debt. While legally classified as equity, representing ownership, they behave in many ways like bonds. This dual nature positions them distinctly within a company’s capital structure, typically ranking above common stock but below all forms of debt.

Companies issue preferred stock to raise capital without diluting common shareholders’ voting power or taking on additional debt. Preferred shares typically have a par value, and their dividends are often calculated as a percentage of this value. This structure provides a predictable income stream for investors.

Various types of preferred stocks exist. Cumulative preferred stock requires that any missed dividend payments be paid to preferred shareholders before common shareholders receive dividends. Non-cumulative preferred stock does not obligate the company to pay missed dividends. Callable preferred stock grants the issuing company the right to repurchase shares at a predetermined price after a specified date. Convertible preferred stock allows investors to exchange their preferred shares for a set number of common shares, offering potential for capital appreciation.

Key Characteristics of Preferred Stocks

Preferred stocks are defined by their fixed dividend payment, which is typically a set percentage of the stock’s par value. Unlike common stock dividends, which fluctuate based on company earnings and board decisions, preferred dividends usually remain constant. This provides investors with a stable income stream. For instance, a preferred stock with a $100 par value and a 6% dividend rate would pay $6 annually.

The distinction between cumulative and non-cumulative preferred stock significantly impacts income reliability. Cumulative preferred stock provides a layer of protection for income-seeking investors, as all missed payments must be paid before common shareholders receive dividends. Non-cumulative preferred stock does not offer this protection, as missed dividends are generally lost permanently.

In a company’s liquidation or bankruptcy, preferred stockholders have a higher claim on assets than common stockholders. They are paid before common shareholders, but only after all bondholders and other creditors have been satisfied. This position in the capital structure offers preferred shareholders a measure of safety compared to common equity.

Preferred stocks typically do not carry voting rights, meaning preferred shareholders cannot vote on corporate matters or elect board members. This absence of voting power distinguishes them from common stock, where shareholders usually have a say in company governance. Investors primarily choose preferred stocks for their income potential rather than for influence over corporate decisions.

Callability gives the issuing company the option to redeem shares at a specified price, often at par value, after a certain date. This call date is typically around five years from issuance, though it can vary. Companies often exercise this right if interest rates decline, allowing them to refinance their preferred stock at a lower dividend rate. This can limit an investor’s potential for long-term income from that security.

Convertibility offers preferred shareholders the option to convert their shares into a predetermined number of common shares. This feature can be advantageous if the common stock’s price increases significantly, allowing preferred shareholders to participate in the company’s growth. However, convertible preferred stocks typically offer lower dividend yields than non-convertible preferred stocks to compensate for this potential upside.

Comparing Preferred Stocks to Other Investments

Preferred stocks occupy a middle ground between common stocks and bonds. Compared to common stocks, preferred shares generally provide a more predictable income stream through fixed dividend payments, unlike common stock dividends which can fluctuate or be suspended. Common stocks, however, offer greater potential for capital appreciation and typically come with voting rights. Preferred stocks usually have less price volatility than common stocks but also offer less growth potential.

In contrast to bonds, preferred stocks share similarities in their fixed income payments and their position in the capital structure above common equity. However, preferred stocks are equity instruments, meaning they do not have a maturity date like most bonds. While both offer regular payments, bond interest payments are generally prioritized over preferred dividends in the event of financial distress.

The tax treatment of preferred stock dividends often differs from bond interest. Most preferred stock dividends are classified as “qualified dividends” by the Internal Revenue Service (IRS), taxed at lower long-term capital gains rates (typically 0% to 20%). To qualify, specific holding period requirements must be met, generally holding the stock for at least 61 days during a 121-day period around the ex-dividend date. In contrast, bond interest is typically taxed as ordinary income, which can be subject to higher marginal tax rates (potentially up to 37%).

Despite the tax advantage, some preferred stock dividends, such as those from certain trust preferreds, are taxed as ordinary income. Preferred stocks carry more credit risk than investment-grade corporate bonds from the same issuer because bondholders have a superior claim on assets during liquidation. While preferred stocks offer higher yields than many bonds, this often reflects the increased risk associated with their subordinated position.

Factors to Consider Before Investing

Evaluating the issuer’s credit rating and financial health is crucial before investing in preferred stocks. Credit rating agencies like Standard & Poor’s (S&P), Moody’s, and Fitch assess the creditworthiness of companies and their securities. These ratings indicate the issuer’s ability to make timely dividend payments and repay principal. Preferred stocks are typically rated several notches lower than the senior debt of the same company due to their subordinated position.

Interest rate movements can influence preferred stock prices. Since preferred stocks pay a fixed dividend, their prices tend to move inversely to interest rates. When interest rates rise, newly issued preferred stocks or bonds offer higher yields, making existing preferred stocks with lower fixed yields less attractive and causing their market prices to fall. Conversely, falling interest rates can increase the value of existing preferred stocks.

Market liquidity is a consideration, as some preferred stocks may trade less frequently than common stocks, especially for smaller or less well-known issuers. Lower liquidity can make it more challenging to buy or sell shares quickly without impacting the price. Investors should assess the trading volume and market depth of a preferred stock before committing capital.

The potential impact of call provisions on an investor’s total return should be considered. Companies can redeem callable preferred shares at a specified price, typically par value, after a certain date. Investors might have their shares called back, especially if interest rates decline. This can lead to the reinvestment of capital at a lower prevailing yield, potentially limiting the expected income stream. Understanding the call protection period and the call price is crucial for managing expectations.