Preferred stocks are worth a closer look
Many investors don’t fully understand the advantages and disadvantages of buying preferred stocks. Preferred stock is really a hybrid security more similar to a bond than to a common stock.
The primary advantage is consistent high income with less downside risk than common stocks. The primary disadvantage is that when interest rates increase significantly, the value of preferred stocks decrease.
Preferred shareholders have priority over common stockholders when it comes to dividends, which generate a higher yield than common stock dividends. Most preferred stocks have a fixed rate, although some are variable, in which the rate is based on a benchmark such as LIBOR.
Dividends can be paid monthly or quarterly. Generally, dividends on common stock can’t be paid until dividends are paid to the shareholders of preferred stock. If a preferred stock is “cumulative,” then preferred stockholders would receive their dividends in arrears before any dividends can be paid to common stockholders.
Preferred stock generally has no specific end date, unlike all bond issues. However, preferred stock generally does have “callable” provisions, which allows the board of directors of the company to purchase outstanding preferred stock at par value after a set date. However, this provision would only be an option if interest rates decrease after the initial issue of the stock.
In the case of liquidation, a preferred stockholder’s claim is greater than common stockholders but subordinate to bondholders.
Some preferred stock is convertible to a specific number of shares of common stock under certain circumstances. Naturally, this feature is attractive when the common stock price increases. However, most issues are not convertible.
For income more than growth
In general, investors should look at preferred stock with the objective of high income, not capital growth. For example, currently the largest preferred stock ETF, iShares Preferred and Income Securities ETF (PFF), has a trailing 12-month yield of 5.61% and an expense ration of 0.46%.
Regarding capital growth, even if a company increases its earnings dramatically, it will not have a significant effect on the net asset value of a preferred stock fund unless the preferred is convertible. Investors who are interested in capital growth should be primarily investing in common stock equities, not preferred stock.
For investors who have established a specific allocation to fixed income, and are interested in high income, they can consider preferred stock for part of that allocation.
My recommendation would be an investment in one of the large diversified popular ETF’s such as PFF, First Trust Preferred Securities and Income (FPE), or VanEck Vectors Preferred Securities ex Financials (PFXF). Yields are stable, currently over 5%, and you can re-invest the dividend income back into the funds. You can compare other preferred ETFs at Morningstar.
According to the Wall Street Journal, over the last 10 years, preferred stocks underperformed the S&P 500 index and long-term bonds (S&P: 13.52%; preferred stock: 7.29%; long-term bonds: 7.7%). However, preferred stocks were much less volatile than common stocks and long-term bonds over that 10-year period.
In general, both preferred stocks and long-term bonds have a low correlation to the stock market indexes. It’s likely that, as long as major banks remain stable financially, a moderate investment in preferred stock ETFs will provide some stability in your portfolio.
Elliot Raphaelson welcomes your questions and comments at email@example.com.
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