Preferred Stock As An Investment
To begin to see if preferred stocks are right for you, we need to do a brief recap of a publicly traded corporation's financial structure. As you should be aware, corporations need money in order to buy plants and equipment, and to get this money they issue both stocks and bonds. Stocks are for those investors who are willing to take ownership risks for ownership rewards; bonds for those willing to accept creditor risks for creditor rewards.
Smack in the middle and a hybrid of these two is a lesser-known entity called a preferred stock. Simply put, it's like a bond in that it typically, but not always, pays a fixed, non-adjusting rate. However, it differs from a bond in two key areas: It effectively never matures and it is junior to bonds in the corporation's chain of liabilities (bond holders eat first, then preferred stock holders and lastly, the leftovers go to the common stock holders).
Preferred stocks are like their common stock cousins in that the dividends can only be paid from company profits. If there are no profits, there are no dividends. But they differ from common stocks in two key areas: First, the dividends are typically cumulative. In other words, if the company misses a payment, it owes the preferred stock shareholder, it cannot pay any dividends to the common stockholders until all preferred stockholders are paid. Second, the preferred stock dividend is typically much greater than the common stock dividend.
Another benefit of the preferred stock is that its yield is often greater than that of the bond. Yes, you read that right! Thus, income-wise, a preferred stock is "safer" than a common stock and can pay more than a bond. When you buy a preferred, you are effectively locking into that day's yield. No more wild interest rate rides.
But before you decide to run off and load up on thousands of shares of preferred stocks, you should do your homework and also bear in mind a caveat or two.
You need to remember that preferred stocks are interest-rate-sensitive. In this case, it simply means that whenever rates go up, the prices of preferred stocks go down - and vice versa.
Currently, rates are relatively high. This means that the potential investor in preferreds has a double opportunity. First, with high rates, you obviously get the opportunity to lock in high rates. Secondly, when rates start to go back down, preferred prices will go up. So you can get high yields and capital appreciation in one package. But a preferred stock is only as good as its corporation so you should stick with "A" -rated firms or better. And also make sure you understand any call provisions.
Thirdly, as always, spread your eggs around a bunch of baskets. And since there are very few mutual funds or ETFs that specialize in preferreds, you will most likely have to design and select your own portfolio.
* * * * *
Smack in the middle and a hybrid of these two is a lesser-known entity called a preferred stock. Simply put, it's like a bond in that it typically, but not always, pays a fixed, non-adjusting rate. However, it differs from a bond in two key areas: It effectively never matures and it is junior to bonds in the corporation's chain of liabilities (bond holders eat first, then preferred stock holders and lastly, the leftovers go to the common stock holders).
Preferred stocks are like their common stock cousins in that the dividends can only be paid from company profits. If there are no profits, there are no dividends. But they differ from common stocks in two key areas: First, the dividends are typically cumulative. In other words, if the company misses a payment, it owes the preferred stock shareholder, it cannot pay any dividends to the common stockholders until all preferred stockholders are paid. Second, the preferred stock dividend is typically much greater than the common stock dividend.
Another benefit of the preferred stock is that its yield is often greater than that of the bond. Yes, you read that right! Thus, income-wise, a preferred stock is "safer" than a common stock and can pay more than a bond. When you buy a preferred, you are effectively locking into that day's yield. No more wild interest rate rides.
But before you decide to run off and load up on thousands of shares of preferred stocks, you should do your homework and also bear in mind a caveat or two.
You need to remember that preferred stocks are interest-rate-sensitive. In this case, it simply means that whenever rates go up, the prices of preferred stocks go down - and vice versa.
Currently, rates are relatively high. This means that the potential investor in preferreds has a double opportunity. First, with high rates, you obviously get the opportunity to lock in high rates. Secondly, when rates start to go back down, preferred prices will go up. So you can get high yields and capital appreciation in one package. But a preferred stock is only as good as its corporation so you should stick with "A" -rated firms or better. And also make sure you understand any call provisions.
Thirdly, as always, spread your eggs around a bunch of baskets. And since there are very few mutual funds or ETFs that specialize in preferreds, you will most likely have to design and select your own portfolio.
* * * * *
posted by Bob Moser at
7:01 PM
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