Yahoo Finance Why Preferred Stocks Belong in Your Portfolio
Preferred stocks were not on the radar of most investors until a few years ago. When bond yields began to fall, investors started hunting for yield in other places and discovered preferred stocks. But what exactly are preferred stocks, what advantages do they offer investors, and why do they belong in your portfolio?
Preferred stock is issued by a company to raise capital for a variety of uses. It isn't equity that provides direct ownership in the company, and it isn't debt, which usually requires some kind of collateral to secure the debt. Ed Butowsky, managing partner of Chapwood Investments in Addison, Texas, describes preferred stock as "very similar to a bond. However, it resides below company bonds and bank obligations in the capital stack, but above common stock."
Thus, should the company become insolvent, any assets or cash flow are first paid to satisfy debt obligations, since those were likely pledged as collateral. If any assets are left over, they are then disbursed to preferred stockholders before common stockholders get anything back.
"Preferred stockholders do not have the legal right to force a firm into bankruptcy," says Cliff Smith, a finance professor at the University of Rochester. "Therefore, if a firm fails to pay dividends to the preferred stockholders, the contract terms determine the consequences, not the bankruptcy court. Only if a firm fails to make an interest payment to debtholders does default occur, which allows the debtholder access to the bankruptcy court."
Also, preferred dividends cannot be cut or suspended unless common stock dividends are cut first. In fact, most preferred dividends are cumulative, so they still accrue even when a dividend is cut or suspended, and they must be paid out before common stock dividends resume.
Preferred shares trade like stocks on the exchanges and are more liquid than bonds. They tend to trade in fairly tight ranges, so they share another trait with bonds in that regard.
Why do companies issue preferred stock? "A company may issue preferred stock because it needs some capital, but doesn't have enough collateral to draw down more debt. Nor does it want to issue common stock because it dilutes the value of existing stock for current shareholders," Butowsky says. "You will see financial services companies, like the big banks, issue preferred shares the most."
The big attraction of preferred stocks is their dividend yield. Most pay above 5 percent annually, and can pay 8 percent or more. As a result, some trade above the par value that they were originally issued at because investors are willing to pay a bit more than par to obtain the higher yield.
"I have no trouble buying preferred stocks at $26.50 or even $27, for a great company with a high yield. I would shy away from anything trading much over that, or closer to $28 per share," Butowsky says. While most preferred stocks are issued at a par value of $25 per share, they also have a call date, like a bond does, which permits the company to buy back the preferred stock at $25 on or after a specified date.
Preferred stocks are taxed like common stocks. However, while the dividends are taxable to the stockholders, they are not deductible by the corporation.
When might a company call their preferred shares? "The most common reasons are its balance sheet has improved so dramatically that it can afford to buy those shares back and save money not paying out dividends over the long term," Butowsky says. In addition, he says, market conditions may change between the time the shares were issued, "such that a company can buy back high-yield preferred [shares] and then reissue new shares at a lower yield. We saw many preferred issues get called in the early 2000s."
Smith points out a couple of other cases where preferred stock might be called. "Sometimes the company's tax circumstances have changed. The call allows a firm that finds itself in a higher corporate tax bracket the option to replace the preferred stock with debt. This occurs when the preferred dividend is not a tax-reducing expense to the company, and the interest payments are deductible," he says.
Preferred stock sounds great, so one may wonder why investors should hold bonds at all. After all, preferred stocks pay much higher dividends, are usually issued by companies that are highly solvent and producing strong cash flow, often trade in a tight and stable price range and rarely become worthless.
"I would not buy any bonds with maturities longer than three years," Butowsky says. "Interest rates on competitive investments, such as long-term bonds, would have to rise well into the 5- to 6-percent range to even begin considering scaling out of preferreds. That is simply not going to happen in the next five years. I would not buy any bonds now, since when interest rates do go up, bond prices will go down, and you will lose money on that investment."
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