Lately Iāve been demonstrating different ways to supplement your dividend income.
For instance, this can be done on the ownership side by selling covered calls or on the buying side by selling cash-secured puts.
Neither of these methods are for everyone. Making these sorts of agreements brings an added layer of complexity that may not be worth it for your typical buy-and-hold, āset it and forget itā type of investor.
Yet for those looking to increase their cash flow, these two methods are certainly worthy of consideration.
Today Iād like to talk about a third avenue for finding an above average cash flow stream: preferred shares.
Once again, this isnāt necessarily a recommendation, but more a means by which to gain awareness of an additional investment possibility. In detailing this possibility, Iād like to keep it straightforward; you can always get more complicated, but it can be hard to get back to the basics.
What Is a Preferred Share?
A preferred share (or stock) is technically an equity stake in a business, but it shares characteristics of what you would find with both equity and bonds.
The equity part is that it has an underlying claim on the business and you collect dividends. The bond-like portion is that the dividends that you receive are fixed payments.
Whatās So Preferential About Them?
Good question. Hereās a look at the basic corporate capital structure:
Source: Market Realist
In the event of bankruptcy or liquidation, preferred equity ranks below debt but above the common equity shares of a company.
The risk that the above chart is talking about relates to the likelihood of being paid back in the event of an adverse circumstance. With an ongoing,Ć profitable business such as Coca-Cola (KO) or U.S. Bancorp (USB) all of these components are satisfied completely.
The potential returns associated with each segment is generally opposite of what you see above.That is, common equity generally has a higher expected return compared to debt in the long run.
This doesnāt always have to hold, but itās generally the case.
Note: Many preferred shares are found in the financial (banks and REITs) or āfixed assetā business like utilities, so your typical dividend growth company may not issue preferred shares at all.
You likely donāt own preferred shares for their slight protection in the event of bankruptcy. While your claim might be greater than the common shares, it could still be quite low.
The true benefit of being āpreferential,ā in my view, is thatĆ the dividend payments are preferential as well.
In order for a company to pay its common dividends it must first satisfy its preferred dividends (if applicable) in full. This has an important ramification in poor but not devastating times.
For instance, during the Great Recession, Wells Fargo (WFC) was forced to cut its common dividend from 34 cents per quarter to just 5Ć cents. For the common equity holder this was a large blow to annual income, and an event that affects your income for many years.
Things turned out differently for the investor who owned preferred shares in Wells Fargo. Because the company was still paying a common dividend ā albeit a significantly reduced one ā that meant that Wells Fargo had to first satisfy its preferred dividends in full. So the preferred share owner who was collecting a, say, 6% annual preferred dividend, kept on receiving their full payments. The preferential nature provided a benefit in this instance.
Basic Features of Preferred Shares
For this section Iād like to talk about some basic features that you might run across as you learn more about preferred shares.
Basic Feature #1: Preferential Dividend
This aspect was just talked about, but itās worth repeating as this could be the second largest draw of owning preferred shares.
If a common dividend is being paid ā regardless if it's 50% higher or lower than it was (even if only a penny) ā the preferred dividends are being paid in full.
Basic Feature #2: Fixed Payments (More Common)
Often preferred shares come with a fixed rate that will be paid in perpetuity. So as an example, a preferred share might have a 6% yield that will be paid every year.
The advantage, and sometimes largest draw, is the above average dividend yield. The disadvantage is that this payment will not be increased. This is quite unlike what many dividend growth investors have come to expect for their payouts over the years.
Basic Feature #3: Floating Payments (Less Common)
Although a fixed payment is common, you can also have floating rate preferreds.
These securities either start with a floating rate, or have a fixed rate for a time before switching over to a floating rate. The rate is often based on a well-known benchmark such as LIBOR.
Basic Feature #4: Lack of Voting Rights
Generally preferred shares do not have voting rights, like common equity does. This likely doesnāt make a difference for the small investor, but it is a reason why management may prefer to issue these shares instead of common ones (among other reasons).
Basic Feature #5: Cumulative vs. Non-Cumulative
Preferred shares can either be ācumulativeā or ānon-cumulative.ā
If a preferred share is ācumulative,ā this means that if the company were to miss or not pay any preferred dividends then they would have to make up those missed payments before reinstating the common dividend. A lot of investors look for this feature, but really you donāt want it to get to that situation. Youād much prefer the company to continue paying dividends on the common shares and not to have to worry about the company paying you back later.
Basic Feature #6: Perpetual
Unlike most bonds, preferred stock can be outstanding forever, or as long as the company is around.
Basic Feature #7: Callable
While the preferred shares may not have an expiration date, they could be ācallable.ā
This means that the company has the option to redeem the shares at a certain price after a date in the future.
So for instance, a company might issue perpetual preferred shares in 2016 with a call date in 2021. This means that if you bought these shares youād receive your dividend payments (presuming they are being paid) for the first five years at least. Thereafter itās at the companyās discretion whether or not it wants to keep the preferred shares outstanding or to buy them back.
A company might reissue new preferred shares and redeem the outstanding ones if rates decrease in the future. As an example, if a company has preferred shares paying 8% outstanding and can now sell 6% preferred shares, it could issue new shares at 6% and buy back your 8% shares. There are some special circumstances, but generally this can only be done if itās after the call date.
So in keeping with the example, you might be able to hold the shares for five years or 100 years, depending on the prevailing rates and what the company wants to do.
Basic Feature #8: Liquidation Preference
Youāre probably asking, āWhat is this ācertain price?āā
The price at which a company can buy back the preferred shares, after the call date, is called the liquidation preference. Often this is the price at which shares were originally sold. As an example, if the preferred shares are sold at $25, this might also be the liquidation preference. You might buy at $25, collect five yearsā worth of dividend payments and then the company could repurchase your shares for $25.
Note that preferred shares trade on the secondary market just like common shares. So the market price of a preferred share can be higher or lower than the liquidation preference, based on the likelihood of the share being bought back and the prevailing rates at the time. This means that your return can be higher or lower than just the dividend payments, based on your original purchase price.
Basic Feature #9: Convertible
Some preferred shares have other features like being convertible.
This means that preferred shares are convertible into common shares at either a fixed rate or depending on some other factor, like the common share price in the future.
The convertible portion may be optional (i.e. at the ownerās discretion) or mandatory ā set for a certain date.
There are a lot more features out there ā participating, supervoting, etc. ā but for our purposes the above notes should serve as a reasonable baseline.
From here Iād like to talk about my personal experience and provide a āreal lifeā example of something that is available today.
A Personal Story
Iāve shared this story previously, but I think it serves as a nice baseline of how I think about the securities.
In general I prefer common shares (the returns are apt to be higher), so I need preferred shares to look comparatively attractive.
The year was 2013 and I remember it like it wasā¦ well about three years ago. Hereās a bit of my experience related to owning preferred shares:
At the end of 2013 I began acquiring preferred shares in U.S. Bancorp (USB), JPMorgan (JPM) and Wells Fargo (WFC). At the time each security had similar characteristics: $25 starting value, not callable for a few years, perpetual, non-cumulative, qualified dividends, etc. During this time, shares could be purchased for around $20 per share, resulting in dividend yields in the 6.5% range.
That seemed like a reasonable enough value proposition to me. I would collect a 6.5% qualified dividend yield and if the companies wanted to call the securities they would have to pay me a 25% premium to do so.
It didnāt quite work out that way, but I was happy with the result. Shortly after my purchases the share prices increased steadily, approaching and even eclipsing the liquidation preference of $25 per share. Ordinarily I donāt like to sell (as Buffett would have it: āMy favorite holding period is foreverā), but in this instance the value proposition had faded away. The 6.5% yield turned into 5.2% and the ābuyout premiumā had also evaporated.
So I sold my stakes, with annual total returns in the 20% or greater range. Moving forward Iād be surprised if these same securities provided such returns in the coming years. Unlike common shares, preferred stock tends to be anchored somewhat by the starting price, so the key can often be buying shares below the liquidation price.
Now I donāt bring up this example to boast. Given the option I would have liked for the shares to stay around $20 or go lower such that I could accumulate more. I provided this actual demonstration to show that it can be useful to monitor preferred shares in addition to common ones. They offer aĆ separate return proposition that can occasionally oust that of your typical stock holding.
A Real Life Example
Of course knowing that some preferred shares traded around $20 in the past is about as useful as me telling you that shares of Walgreens (WBA, Financial) started 2013 trading around $37 (as compared to a more recent quote of $83).
Itās nice to have a solid history and process in mind, but really you want to think about what is currently happening.
So letās work with a āreal lifeā example ā something that you could look at today, if you so choose. And by the way, this is in no way a recommendation, just the process of how you might go about searching.
With common shares thereās a bevy of investing websites that will give you information on the security. With preferred shares the amount of information can be lacking.
Incidentally, this is also a clue as to a potential downside ā the liquidity of preferred shares is apt to be much lower than common shares, so this can be an important consideration. One place that you can go is this website:Ć dividendyieldhunter.com.
The very first option next to the siteās title will be āPreferreds,ā which gives you a drop down menu of a variety of preferred share alternatives. For this demonstration I selected the eighth option ā āPreferreds ā Qualified Dividends.ā
This page will give you a table of preferred issues whose dividends are eligible for qualified status. Note that the holding period for qualified preferred dividends is a bit longer than for common dividends, but the same lower tax rates can apply.
Hereās what that table will look like:
You start with the security description, followed by the ticker, issue price, current price and so on.
For those first learning about preferred shares, the most relevant aspects to start are likely going to be:
- The current price in relation to the call price.
- Whether or not the issue is cumulative.
- The current yield.
- Earliest call date.
- Rating.
To continue with the example, Iāll pick out a preferred issue, say āJPM-A.ā Again, this is not a recommendation but merely a description of how you might learn more about a particular security.
If you click on this security on the Dividend Yield Hunter website itās going to give you a little bit of information, but not much more than what is already listed in the chart.
I find that this website is useful to look at a wide range of securities simultaneously, but not necessarily to ādrill downā into the details. For that purpose, I like to use Quantum Online.
You can get the same types of tables on this website, but it does require you to register. If you want to look up information without registering, you can do so, but you have to know roughly what youāre looking for.
On the right-hand side of the website there is a āquick searchā box.
If you put in āJPMā it will take you to its JPMorgan Chase & Co. page with general information. Underneath the companyās profile, thereās a link called āFind All Related Securities for JPM,ā which will bring up ā you guessed it ā all the securities related to JPMorgan.
From here you can click on āJPM-Aā and it will provide you with a good amount of detail on that particular security. Along with a lengthy paragraph talking about the security, it will also show you summarizing information as you see below:
This is a great source of information and can help give you a feel for the underlying security. Although perhaps dull to read, I find that the link to the prospectus is also helpful.
We could have just input āJPM-Aā from the beginning when we first got to the Quantum Online website, but this is the process of finding a security if you donāt know the exact ticker.
Additionally, some websites use a different format for preferred shares. For instance, on dividend.com itās simply āJPM-A.ā On Yahoo Finance itās āJPM-PA.ā And for your brokerage account it could be āJPMpA.ā Itād be nice if it were standardized like common tickers, but here we are anyway. The point is that you shouldnāt get discouraged if you donāt immediately find the information that youāre looking for.
Other websites also have more information besides these two, and you can goĆ directly to the companyās website.
What Does This Mean in Terms of Potential Returns?
So far weāve talked about the features of preferred shares and how you might learn more. Now letās think about the potential return that these sorts of securities can provide. Weāll stick with āJPM-Aā to continue with the example.
The ācoupon rateā (really a dividend rate) for the security when it was issued was 5.45% based on a price of $25. This $25 mark also happens to be the liquidation preference, so that will be important to keep in mind. Investors will receive an annual dividend of $1.3625 for each depository share they own. This will be paid in four quarterly installments on March, June, September and December 1.
The shares do not have a maturity date, so they could be outstanding āforever.ā However, JPMorgan does have the option to buy the shares back anytime starting on March 1, 2018, or thereafter. So letās think about owning shares through this date.
You would receive three more dividend payments for 2016, totaling $1.03. For 2017 youād expect to receive four full payments and one more for 2018. Over the next two years you would anticipate collecting eight quarterly $0.340625 payments for a total of $2.73.
Based on a share price around $25.45 as I write this, you would anticipate collecting approximately 10.7% of your initial capital back in the next two years. If the shares are not called you would go on collecting your 34 cent quarterly dividend until you decide to sell or if the shares are eventually called sometime in the future.
If the shares are called you would still receive approximately $2.73 in dividend payments to go along with $25 per share. Your total value would be $27.73, or a total gain of roughly 9%. Note that this is lower than the dividend component by itself because the company is able to buy back the shares below your cost basis. Your annualized gain for this period would be about 4.4%.
Personally, I donāt find this particularly attractive (especially in comparison to your alternatives) but thatās not exactly the point. The point is to be aware of these types of securities should something interesting occur. As a hypothetical, if shares were trading around $20 instead of closer to $25.50, your starting yield would go up to 6.8% and your annualized āreturn to callā would be near 18%. Granted there is no force that requires a company to call your shares, but it should be clear that the price of the security dictates whether or not it may be attractive.
A final thing to consider is that the common shareholders are effectively issuing the preferred shares. (Not literally, but the company is doing so on behalf of its owners.) As such, it follows that the common shareholder ought to expect to be able to generate returns that outpace what they have to pay in preferred dividends.
This isnāt always the case, but generally preferred shares are issued with the intent to use those funds for an endeavor that provides higher returns. If you can generate a 10% return on the funds you receive, it can make sense to issue a 5% or 6% preferred. Thus the first comparison for owning preferred shares ought to be the common shares of a company.
Final Thoughts
Thatās the nuts and bolts for getting familiar with preferred shares.
The advantage of owning preferred stock is that you begin with a higher starting income, the dividend is preferential (even if the common payout is reduced) and these payouts can still count as qualified income.
The main disadvantage relates to the potential returns and structure of the securities. Over the long term your total return (and perhaps even total income, although that part is less certain) is apt to be lower. The capital appreciation of preferred shares can be limited or even non-existent. Moreover, the liquidity for being able to buy or sell shares may not exist in a way that you have been accustomed to with common equity.
It all comes down to your personal investment preferences. If youāre happy to collect a 5% yield with limited upside but a bit of dividend protection, there are a lot of securities like that out there today. Alternatively, if youāre looking for a bit higher yield and/or return possibility, the majority of preferred issues may not appear attractive at present. But that doesnāt mean you ought to write them off completely.
By being aware of the security class you can revisit this possibility in the future to see if anything interesting is being offered.