Have you ever wished for the safety of bonds, but the return potential of common stocks? If so, preferred stocks are potentially a good choice to explore.
Preferred stocks are generally safer than common stocks, but they often offer greater returns and income than bonds. Preferred stocks are not for everyone, and just like with common stocks, it is important to do your own due diligence about the companies you are considering investing in. But for the investor who likes income with a side of safety, preferred stocks may be just the right order.
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Essential Facts About Preferred Shares
Preferred stocks are often referred to as hybrid securities because they have elements of both common stocks and bonds. Preferred stocks are often issued by banks, utilities and REITs, among others. Before investing in preferred stocks, one must keep in mind the following considerations that differentiate preferred stocks from other investment vehicles.
Preferred stock shares are not new – in fact, preferred stocks generally predate common equity. A century ago, most of the reputable companies that were publicly traded offered preferred shares. Warren Buffett’s mentor Benjamin Graham wrote extensively about preferred stocks in his treatise The Intelligent Investor.
Today, while common stocks have grown markedly in popularity, there are still plenty of preferred shares out there as well.
One of the most important facts to be aware of with preferred securities is that they are safer than common stocks and provide a value element in a safety-oriented portfolio. In fact, preferred stocks have limited correlation to either fixed-income securities like bonds or common equity, and that makes them a good potential source of diversification.
In addition, preferred shares are senior in the capital structure to common equity (but below bonds and bank loans). As a result, in a bankruptcy situation preferred shareholders generally recover more money than common equity. That is not to say that preferred shareholders won’t be significantly hurt by a bankruptcy – they will be – but they are in better shape than the mass of common equity investors.
While you are learning about preferred stocks, you might want to check out our Dividend Investing Ideas Center to learn about more ways to generate recurring income.
Like many common stocks, preferred shares pay dividends. Unlike common stocks, though, preferred shares always pay dividends and these dividends are more secure. The yield on a preferred stock is determined at issuance based on the par value of the preferred. A 4% yield on a $25 preferred stock means that the preferred holder will receive $1.00 per year.
While this dividend generally will not rise, many preferred stocks are cumulative preferred, meaning that the preferred stock dividends are paid before common stock dividends, and if preferred stock dividends are ever suspended, all dividends owed in arrears must be paid in full before any dividends can ever be paid to common shareholders in the future.
In addition, because preferred stocks are still equity, they often have a considerably higher yield than bonds for a given company. A quick look at our list of preferred stock issues shows many securities yielding 7% or more, compared with corporate bond yields that are often 6% or less.
Preferred stocks generally have a higher rate of return than fixed-income securities because they are a bit riskier than conventional bonds, and because they are often less liquid than either major corporate bonds or common equity. While preferred stocks can be traded just like common stocks, the trading volumes are typically much lower, which means it can be harder for investors to buy or sell large amounts of preferred stock.
3. Other Considerations
Preferred stocks are often less volatile than common stocks, but more volatile than bonds. While bonds trade in very large blocks most of the time, a company’s bonds will often trade only a few times each day. In contrast, preferred shares trade much more frequently, but their price is more stable than that of common stocks. This can be a major benefit for investors who don’t like seeing the fluctuations associated with common shares.
One of the benefits of common stocks is the right to vote on important issues such as the election of a company’s board, and M&A decisions. Preferred stocks do not usually carry voting rights, and as a result, preferred shareholders do not get a say in the firm’s major decisions. This facet of preferred stocks mirrors that of bonds.
Still, for many shareholders, voting rights are of secondary importance, so this feature probably won’t drive your final investment choice on the security either way.
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The Bottom Line
Preferred stocks offer a combination of attractive features from both common stocks and bonds. Major companies including banks, utilities and REITs all offer preferred stocks that may be good investment options for many investors.
However, preferred stocks are not for everyone. The securities generally do not have as much total return potential as common stocks over the long run. However, for income investors, preferred stock can be very appealing. Preferred shares usually carry higher yields than either common stocks or bonds, and that income is secure under all but the most difficult of times for the company.
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