The Many Flavors of Preferred Stock

Understanding the Pros and Cons of Investing in Preferred Stock

Preferred Stock Investing
Preferred stock is a sort of hybrid between a stock and a bond typically featuring limited capital gain potential with above average dividend yields.. DNY59 / E+ / Getty Images

Preferred stock is a hybrid between common stock and a bond. Each share of preferred stock is normally paid a guaranteed dividend which receives first priority (i.e., the common stockholders cannot receive a dividend until the preferred dividend has been paid in full) and has dibs over the common stockholders, but underneath the bond investors, if the company needs to liquidate assets in a bankruptcy proceeding.

The trade-off for the often substantially higher dividend yield received by preferred stock holders is the inability to grow their investment substantially as the enterprise expands.  Unless there are other, special provisions that exert a larger influence, preferred stock prices are extremely sensitive to changes in interest rates and relative yields on competing investments.  This means that any capital gains enjoyed by the owner will likely come from buying prior to an interest rate decline and/or an increase in the creditworthiness of the firm, causing other investors to be willing to accept a lower dividend yield.

The terms of preferred stock issues can vary widely, even among the same corporation which may issue multiple preferred stock "series", as they are frequently called. Arguably, the most important characteristic of a preferred stock is whether or not the dividend is cumulative or non-cumulative.

In a cumulative issue, preferred dividends that are not paid (referred to as "in arrears") build up. Before any dividend can be paid on the common stock, the entire in arrears balance must be distributed to the preferred stock investors in full. If a preferred issue is non-cumulative and a dividend payment is missed, the preferred shareholders are out of luck as they will never never receive that money from the company even if and when the firm is fortunate enough to return to more prosperous times.

Provisions That Can Influence Preferred Stock Value

There are a number of additional provisions that can affect the value of a preferred stock. Here are just a few:

  • Voting vs. Non-Voting: Owners of preferred stock may or may not have voting rights. There have been cases throughout history in which preferred shares only received voting rights if dividends had not been paid for a stipulated length of time, effectively transferring a significant, if not controlling, voting power to the preferred investors. Such a provision effectively puts the preferred shareholders in the position of a first mortgage bond holder by giving them the collective power to enforce payment on their claim, resources permitting.  This is frequently done in certain private equity deals, special financing arrangements with public companies, or other non-standard situations where the de facto lender doesn't want to pay the substantially higher taxes that would be owed on interest income had bonds been issued.
  • Adjustable rate preferred stock: Holders of the preferred stock receive a dividend that differs based on any number of factors stipulated by the company at the issue's initial public offering.  Over the course of the past decade, it has become fairly common for new preferred stock issues to have floating rate dividends to reduce the interest rate sensitivity and make them more competitive in the market.
  • Convertible preferred stock: Holders of this type of security have the right to convert their preferred stock into shares of common stock. This allows the investor to lock in the dividend income and potentially profit from a rise in the common stock while being protected from a fall in the same.  Under the right conditions, with the right business, an intelligent investor can make a lot of money while enjoying higher income and lower risk by investing in the convertible preferred stock first.  To learn more about how this works, read Convertible Preferred Stock for Beginners.
  • Participating preferred stock: Normally, shares of this type of preferred stock receive a set dividend plus an additional dividend based upon a stipulated percentage of either the net income or the dividend paid to the common stock holders.

The variations for preferred stock can be endless. It is quite possible an investor could come across a non-voting cumulative participating convertible preferred issue. Due to the individuality of the preferred stock field, we must stick to generalizations.

Understanding How Preferred Stock Prices Are Influenced By Changes in the Common Stock

If a large drug company discovered a cure for the common cold, the common stock would go through the roof in anticipation of the tens of billions of dollars the shareholders expect to earn in the future. At the same time, the company's preferred shares probably wouldn't budge much in price except to the extent that the preferred dividend is now safer due to the higher earnings coverage that will be enjoyed; a change of events that could lead to the market value of the preferred rising and the yield falling. Nevertheless, the preferred shareholders would have missed out on the huge capital gains, albeit while collecting dividend checks. If, two weeks later, the company announced that the cure is not effective, the common stock would plummet. What happens to the company's preferred shareholders? Not much as long as the business is still making the respective preferred stock dividend payments.

However, if the investor had owned convertible preferred shares in this scenario, the price of convertible "percs", as they're known, would have experienced a tremendous rise and fall based on the expected profit an investor could have realized by converting his shares into common stock. As long as the holder of the preferred did not convert his shares or acquire more preferred at the inflated price, he would experience no loss of principal. (Perhaps now is the time to repeat the old Wall Street maxim that is dubious at best but nevertheless famous among older generations, "Never convert a convertible stock".)

Who Should Invest in Preferred Stock?

In many ways, the insulation preferred stock appears to offer shareholders can seem attractive. The truth is, preferred stock probably doesn't make much sense for individual investors.  

On the other hand, preferred stock investments can be a goldmine for corporate portfolios. Why? Federal tax laws only require companies to pay income tax on 30% of their preferred dividends, meaning a full 70% is essentially tax-free!  This exemption is not available to individual investors.  Your portfolio will probably receive a higher after-tax yield by investing in corporate bonds when rates are attractive enough or municipal bonds if you are in a higher tax bracket (to determine which, you need to calculate something known as the taxable equivalent yield). Equally as important is the fact that, as a bond investor, you will likely receive a senior claim in such investments as opposed to the subordinate position offered by most preferred stocks.

No matter what you do, it might be wise to remember the adage of legendary investor, teacher, and money manager Benjamin Graham who emphatically stated that it was almost always a mistake for an investor to buy a preferred stock issue at or near par value as history has repeatedly shown, if he or she is patient enough, the opportunity to own it at substantially reduced values will most likely present themselves.  

Read More About Investing in Stock or Bonds

You can find more information about investing in stock in our Complete Guide to Investing in Stock.  You might also want to check out 3 Bond Strategies for Long-Term Investors.

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