Preferred Stocks: Higher Yields from Hybrid Securities

Introduction to Preferred Stocks

Preferred stocks are hybrid securities that incorporate elements of both stocks and bonds. They represent ownership in a company (like common stocks) but typically pay fixed dividends at regular intervals (like bonds).

The Hybrid Nature of Preferred Stocks

Preferred stocks occupy a unique middle ground in the capital structure:

• Between Debt and Equity: Senior to common stock but junior to bonds
• Fixed Income Characteristics: Predictable dividend payments and par value
• Equity Characteristics: Represent ownership and trade on exchanges
• Yield Advantage: Typically offer higher yields than corporate bonds from the same issuer

Market Overview

The U.S. preferred stock market encompasses approximately $350 billion in total issuance. Financial institutions (banks, insurance companies) dominate the preferred market, accounting for roughly 60% of total issuance, followed by utilities and telecommunications companies.

Key Features of Preferred Stocks

Preferred stocks have several distinctive characteristics that set them apart from both common stocks and bonds:

Fixed Dividend Payments

Unlike common stock dividends, which can vary based on company performance and board decisions, preferred stock dividends are typically:

• Fixed in Amount: Usually stated as a percentage of the par value (e.g., 5.75% of $25 par)
• Regular Schedule: Most pay quarterly, similar to common stock dividends
• More Reliable: Companies must pay preferred dividends before paying common dividends

Priority in the Capital Structure

Preferred stockholders enjoy important protections:

• Dividend Priority: Must receive dividends before common shareholders
• Liquidation Preference: Higher claim on assets than common shareholders in bankruptcy
• Position: Senior to common stock but junior to bonds and other debt

Limited Voting Rights

Unlike common shareholders, preferred shareholders typically have limited or no voting rights on corporate matters. However, they may gain voting rights in certain circumstances, such as when the company fails to pay preferred dividends for a specified period.

Types of Preferred Stocks

Preferred stocks come in several variations, each with distinct features that can significantly impact their risk and return characteristics:

Cumulative vs. Non-cumulative

• Cumulative Preferred: If dividend payments are missed, they accumulate as arrears that must be paid before any dividends can be paid to common shareholders
• Non-cumulative Preferred: Missed dividend payments don't accumulate and aren't required to be paid in the future

Convertible vs. Non-convertible

• Convertible Preferred: Can be exchanged for a specified number of common shares at the shareholder's option
• Non-convertible Preferred: Cannot be converted to common stock

Other Important Variations

• Callable Preferred: Issuer can redeem shares at a predetermined price after a specified date
• Adjustable-Rate Preferred: Dividend rate adjusts periodically based on benchmark interest rates
• Fixed-to-Floating Rate: Initial fixed rate period followed by a floating rate period
• Trust Preferred: Issued by a special purpose entity (usually a trust) created by the parent company
• Perpetual Preferred: No maturity date, continues indefinitely unless called by the issuer

Pricing and Yield Considerations

Understanding how preferred stocks are priced and how their yields are calculated is essential for effective investment decisions:

Par Value and Market Price

Most preferred stocks are issued with a par value (typically $25 or $1,000) that serves as the basis for calculating dividend payments and redemption value. The market price fluctuates based on interest rates, credit quality, and other factors.

Yield Calculations

• Current Yield: Annual dividend divided by the current market price (e.g., $1.50 annual dividend ÷ $25 market price = 6% current yield)
• Yield to Call: Total return if held until the earliest possible call date
• Yield to Maturity: Total return if held until maturity (for preferred stocks with maturity dates)

Interest Rate Sensitivity

Preferred stock prices are inversely related to interest rate movements:

• Rising Rates: Preferred stock prices typically fall when interest rates rise, as their fixed dividends become less attractive compared to new issues
• Falling Rates: Preferred stock prices typically rise when interest rates fall, though callable issues may be limited by their call price

Risk Factors

While preferred stocks offer attractive yields, investors should be aware of several key risks:

Interest Rate Risk

Perhaps the most significant risk for preferred stocks. When interest rates rise, preferred stock prices typically fall, similar to bonds. Perpetual preferred stocks with no maturity date are particularly sensitive to interest rate changes.

Credit/Default Risk

If the issuing company faces financial difficulties, it may suspend preferred dividend payments. While many preferred dividends are cumulative, there's no guarantee the company will survive to pay the accumulated dividends.

Call/Redemption Risk

Many preferred stocks are callable after a specified date, typically 5 years after issuance. If interest rates decline, the issuer may call the preferred stock and replace it with lower-cost financing, forcing investors to reinvest at lower prevailing rates.

Liquidity Risk

The preferred stock market is smaller than both the common stock and corporate bond markets. Some issues may have limited trading volume, making them difficult to buy or sell without affecting the price.

How to Invest in Preferred Stocks

Investors can access preferred stocks through several approaches, each with distinct advantages and considerations:

Individual Preferred Shares

Purchasing specific preferred stocks directly through a brokerage account allows you to select preferred stocks with features tailored to your needs:

• Advantages: Select specific features, potentially higher yields than pooled investments
• Considerations: Requires research, monitoring, and sufficient capital for diversification

Preferred Stock ETFs

Exchange-traded funds that invest in a diversified portfolio of preferred stocks:

• Popular Options: iShares Preferred and Income Securities ETF (PFF), Invesco Preferred ETF (PGX), First Trust Preferred Securities and Income ETF (FPE)
• Advantages: Instant diversification, professional management, liquidity
• Considerations: Expense ratios typically 0.35-0.55%, lower yields than some individual issues

Other Investment Vehicles

• Mutual Funds: Similar to ETFs but price once daily at NAV
• Closed-End Funds (CEFs): May use leverage to enhance yields, can trade at premiums or discounts to NAV
• Unit Investment Trusts (UITs): Fixed portfolios with specified terms

Frequently Asked Questions About Preferred Stocks