The Basics of Investing In Preferred Stock
Preferred stock is a hybrid between common stock and bonds. 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 stockholders' dividend has been paid in full). If the company needed to liquidate assets in a bankruptcy proceeding, preferred stockholders will receive their payments (if any money remains) before the common stockholders, but not before the creditors, secured creditors, general creditors, and bondholders.
The trade-off for the often substantially higher dividend yield received by preferred stockholders is the inability to grow their investment substantially as the enterprise expands. Unless there are special provisions that exert a larger influence, preferred stock prices are extremely sensitive to changes in interest rates and relative yields on competing investments. It means that any capital gains enjoyed by the owner will likely come from buying preferred stock 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.
Cumulative vs. Non-Cumulative Preferred Stock
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 the preferred stock is whether or not the dividend is cumulative or non-cumulative.
In a cumulative issue, preferred dividends that are not paid pile up in an account. These unpaid dividends are referred to as "in arrears." Before any dividend can be paid to the common stockholders, the entire in arrears balance must be distributed to the preferred stockholders in full.
If a preferred issue is non-cumulative and the dividend payment is missed, the preferred shareholders are out of luck. They will never receive that money, even if the company produces record-breaking profits months later.
Provisions That Influence Preferred Stock Value
There are a number of additional provisions that can affect the value of a preferred stock. These considerations include shareholder voting rights, the rate of interest, and if shares can be converted to common shares.
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 shareholders. Such a provision effectively puts them in the position of a first mortgage bondholder by giving them the collective power to enforce payment on their claim, resources permitting. It 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.
Holders of the preferred stock receive a dividend that differs based on any number of factors stipulated by the company at the issuer's initial public offering. Over the last 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.
Holders of this type of security have the right to convert their preferred stock into shares of common stock. It 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. Under the right conditions, with the right business, an intelligent investor can make a lot of money while enjoying a higher income and lower risk by investing in the convertible preferred stock first.
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 stockholders.
Even with the few provisions mentioned above, the variations for the preferred stock can be quite numerous. It's possible an investor could come across a non-voting cumulative participating convertible preferred issue!
Common Shares Influencing Preferred Shares
If a large drug company discovered a cure for the common cold, the company's common stock would skyrocket. The growth in market value is in anticipation of the tens of billions of dollars the shareholders would expect the company to earn in the future.
At the same time, the company's preferred shares likely wouldn't budge much in price except to the extent that the preferred dividend is now safer due to the higher earnings. This additional safety can lead to the market value of the preferred shares rising and the yield falling.
Nevertheless, the preferred shareholders would have missed out on the huge capital gains, albeit while collecting dividend checks. If a few weeks later, the company announced that the cure is not effective, the price of the common stock would plummet. Would the company's preferred stock plummet, too? As long as the business is still making the respectively preferred stock dividend payments, its price would remain relatively stable.
However, if the investor had owned convertible preferred shares—Preference Equity Redemption Cumulative Stock (PERCS)—in this scenario, the price of the PERCS 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.
Institutional vs. Individual Holders
In many ways, the insulation preferred stock appears to offer shareholders can seem attractive, but the truth is preferred stock, generally speaking, doesn't make much sense for individual investors.
On the other hand, preferred stock investments can be a goldmine for corporate portfolios. 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 tax exemption is not available to individual investors.
An individual portfolio will probably receive a higher after-tax yield by investing in corporate bonds—when rates are attractive—or municipal bonds if you are in a higher tax bracket. To determine if corporate bonds or municipal bonds offer a higher after-tax yield, you need to calculate the taxable equivalent yield. Equally as important is that as a bond investor, you'll likely receive a senior claim should the underlying company fail as opposed to the subordinate or junior 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 they are patient enough, the opportunity to own it at substantially reduced values will most likely present itself.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.