Many investors are attracted to preferred stock investments due to their generous income yields, but are somewhat mystified by how these hybrid securities work. Is it a stock? Or is it a bond? And when does it make sense as an investment?
Here’s 7 quick facts about this often misunderstood investment category, and why they might deserve a second look:
A little bit stock, a little bit bond. Preferred stock is, of course, called “stock.” But it has much more in common with bonds, and is more accurately a hybrid security with some characteristics of both stocks and bonds. Preferred stocks pay more income than stocks or your typical bonds for that matter, but that juicy yield comes with a higher dose of risk.
While common stock owners have voting rights, and participate in the growth and earnings of the company, preferred stock owners do not, so don’t expect long-term appreciation from your preferred stock investment. However, preferred stock owners have a superior claim when it comes to dividends. Preferred dividends must be paid before any dividends are paid to common stockholders.
Higher income flows. There’s one big reason for income-oriented investors to take a long, hard look at preferred stocks. Preferred stocks can pay hefty dividends. A typical preferred dividend is around 5%. That’s very attractive compared to other bonds. In most time periods and interest rate environments, preferreds pay more income than Treasuries or corporate bonds, but now that spread is even greater than normal.
A focus on financials. Most preferred stocks are issued by established banks, financial or insurance institutions, which tend to have solid and highly regulated balance sheets. Preferred stock owners take precedence over common stock owners, and must receive their dividends before any payments can be made to common stock investors. That puts pressure on company managers to pay preferred dividends on schedule.
Favorable tax treatment. Many preferred securities pay dividends that benefit from lower “qualified” dividend rates. That means they are taxed at a favorable 20% dividend rate instead of ordinary income rates that can climb as high as 37%. As a result, investors can be left with more after-tax income than they would receive from regular bonds.
It’s easy to invest. Years ago, investors interested in preferred stocks would have to buy individual preferred securities. Now, of course, it’s much easier. You can buy a diversified portfolio of preferred securities by purchasing shares of a specialized mutual fund or ETF (Exchange Traded Fund). The advantage? You can spread your investment across several issuing companies for instant diversification.
More price volatility. One downside to preferred securities is they can experience more price volatility than higher quality bonds, and it’s not unusual to see them move in the same direction as stock prices during a stressful or crisis situation. That was the case during the 2008-2009 financial crisis and also in March 2020 as markets reacted to the coronavirus crisis. Preferreds could also be negatively affected by downgrades in the financial quality of issuing companies, amid fears that they would be unable to pay dividends or principal as scheduled. For that reason, preferred securities are more appropriate for investors looking for greater than average income, and willing to tolerate greater than average price movements. Preferreds, like other non-core bonds, should make up only a small part of a diversified fixed-income portfolio.
A good choice when rates are low or declining. As with other longer-term bonds, preferred stocks are sensitive to changes in interest rates. That can be a negative when interest rates are climbing, although higher yields can cushion the impact. However, that interest rate sensitivity can be a plus when rates are low or declining, like now, as preferreds offer investors very favorable yields compared to other investments.