In what Marvin Appel called “a little-known corner of the stock market,” you can find preferred stocks (preferreds). They produce above-average dividend yields and better yields than corporate bonds, and may offer some tax advantages as well. But, there’s a cost: They are riskier than bonds.
According to chapter nine of Appel’s book, "Higher Returns From Safe Investments: Using Bonds, Stocks, and Options to Generate Lifetime Income," preferred stocks trade on stock exchanges like common stocks and exchange-traded funds do. That is, they can be bought and sold at any time during the trading day.
Unlike common stocks, preferred stocks are loans to a company rather than capital investments. Preferreds are also issued like bonds, with a fixed share price, a specified dividend rate and a fixed maturity date.
Also, unlike common stocks, preferred stocks are callable, which means the issuer can buy back your shares if the interest rate falls below the dividend rate on your preferreds. They can be called back at any time after their first five years.
Taxation
There exists an important divide among preferred stocks:
- Some have dividends taxed like bond interest (expensive).
- Others have dividends taxed like common stock dividends (less expensive).
Obviously, lower taxes are generally better than higher taxes, especially when preferred stocks are not held within a tax-advantaged account. Therefore, tax status is an important criterion when shopping.
Price risks
When assessing the price of preferred stocks, investors should consider three factors:
- The creditworthiness of the borrowing company.
- The “attractiveness” of the dividend.
- Whatever call provisions are built into it.
Just as value investors use ratios and metrics to assess the financial stability of a company, preferred investors must also check the ability of the issuing company to sustain the payments of its dividends for years to come.
Attractiveness refers to how well an issue compares in a competitive landscape. What else is available at comparable rates of returns (assuming roughly equivalent risk)? And, then there’s the time factor: If interest rates go up after you buy a preferred, then its face value will go down to make it competitive.
Turning to the call provisions, Appel wrote [author's emphasis]:
“Call provisions are the trickiest to address quantitatively. We have already seen that when preferred stock yields rise, the prices of existing preferred stocks fall. However, the converse might not be true: A drop in interest rates might not boost shares of preferred stocks if the issuer can call the shares."
Credit risks
If a company defaults on its debts, preferred shareholders will lose their dividends -- and quite possibly their entire investment.
First on the default recovery ladder are bondholders, who get 100% if there are enough funds available or all that is available. Assuming there are still funds available after the bondholders get all their money back, then holders of preferred shares get some or all their capital returned. Finally, whatever funds are available after bondholders and preferred stockholders get all their money back, come holders of common stock. So, holders of preferred shares have an advantage over holders of common shares, but in many cases this will prove meaningless.
But, for companies that get into some trouble, but not enough to default, preferred holders have another advantage. They get their dividends before common stockholders. At any time, a company may cut its common stock dividends. But when it comes to preferred stockholders, a company must pay those dividends or else formally default.
Trading preferreds
As noted above, preferred stocks trade just like common stocks and ETFs. Still, Appel cautioned his readers that preferreds are difficult to trade because they are relatively illiquid; not many investors are buying or selling them.
He added:
“Because so many preferred stocks are illiquid, you should make sure you are in love with a stock before you buy it because you should plan on holding it for years. The amount of dividend income has to be attractive enough to make that kind of mental commitment. Of course, if your situation or the situation of the underlying company changes, you are free to sell your preferred shares. Just understand that the decision to sell could cost you 1% of your investment or even more.”
How much of an allocation?
According to the author, you should not invest heavily in preferred shares. He recommended that preferreds not make up more than 10% of anyone’s total portfolio, and that a maximum of 1-2% of that portfolio be invested in one specific issuing company.
Allocations also should be limited because of the fixed dividend yields; at the time Appel wrote this in late 2009, inflation since 1945 had averaged 4% per year. Since then rates have been lower, but investors should be sure that any preferreds they buy have a yield that is high enough to compensate for potentially higher inflation rates.
And, preferred stocks are not likely to deliver any capital gains, even if there are favorable interest rate changes or better credit ratings. Any such gains will likely be nullified by trading costs, and especially by wide bid-ask spreads (as you will recall, these are thinly traded securities).
Variations
So far, chapter nine has covered only conventional preferred stocks. According to Appel, there are several types of preferreds, in addition to the conventional variety. He listed the most prominent of them:
- Trust preferred stocks: These are essentially bonds packaged in the form of preferred stock. Their dividends do not get the favorable tax treatment received by qualified dividends.
- Convertible preferred stocks: Preferred shareholders have the option of converting their holdings into common stock (at a price fixed by the issuer at the time the preferred was issued).
- Auction rate preferred stocks: Leading up to 2008, these were sold at $25,000 per share, and were sold to institutions and wealthy investors.
Appel did not recommend any of these other types of preferreds. And, his recommendation about preferred stocks in general was lukewarm: “Preferred stocks offer potentially attractive yields for the investor who is willing to tolerate some volatility in the share prices. Investors who are seeking attractive levels of interest income can invest up to 10% of their portfolio in a variety of preferred stocks, but should not place more than 1%–2% of their assets in any single company.”
Read more here:Â
Higher Returns From Safe Investments: The Safest SecuritiesÂ
Higher Returns from Safe Investments: Bond Mutual FundsÂ
Higher Returns From Safe Investments: Bond LaddersÂ
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