Have You Considered Preferred Stocks?

We’ve written a few times before about U.S. preferred stocks. These are different from the stocks that make up what we usually think of as the ‘stock market’. The stock market is made up of ‘common stocks’. Each of the two kinds of stocks has its place, and you might very well want to invest some money in both. With common stocks near all-time highs, it is important to consider investment alternatives, as you may not want to commit more money to the stock market at these nosebleed levels.

The ‘preferred’ in ‘preferred stock’ refers to the fact that preferred shareholders have certain rights to the company’s assets, and these obligations must be satisfied before the common shareholders can receive any money.

Preferred shares (or ‘preferreds’) are a sort of hybrid between common stocks and bonds. Like common stocks, they are an equity stake in the company. Preferred shareholders are part owners of the company – they are not creditors, as bondholders are. But preferreds are like bonds in other ways. They do have a set face amount, which is called the issue price, call price or liquidation preference. They also have a fixed payment rate, like a bond’s interest rate. In the case of preferreds, this fixed payment is not called interest, it is called a dividend.  The rate that a preferred stock pays in dividends is usually part of the name of the preferred stock. For example: DDR Corp 6.375% Class A.

This is a preferred stock issued by DDR Corp. The company pays dividends on this stock at the rate of 6.375% of the face value per year. ‘Class A’ refers to the fact that a company may have issued several different series of preferred stocks over the years, with different dividend rates. There might be a Class B, Class C, etc. This is not a recommendation, just an example.

There are a few things about preferred stocks that might make them attractive to you:

• They always pay substantial dividends, that are higher than the interest the same company would pay on its bonds, and usually higher than the dividend yield on its common stock.

• They are higher in the capital structure than common stocks, so in case of trouble they are safer than common stock (although they could still become worthless if the company were to go bankrupt, if there was no money left after paying creditors and bondholders).

• Their prices are not nearly as volatile as common stocks.

• The dividend income may be a ‘qualified’ dividend for tax purposes. If so, in the U.S. the preferred dividends are taxed at long-term capital gains rates of 15% or 20%, rather than at full ordinary income tax rates of up to 37% as bond interest or bank interest would be.

• Because their face amount is small (almost always $25 per share), it is easy to create a diversified portfolio of preferred stocks from several different issuers, even with a small portfolio.

The high cash flow returns from preferred stocks do come with some downsides – there is a reason their yields are always higher than that of the same company’s bonds or common stocks:

• A preferred share is a right to a fixed number of dollars of the company’s equity, not a percentage of its equity like common stock. The price of the company’s common stock can go up over time as the company’s net worth grows. Preferred stock prices do not go up in this way, no matter how successful the company is. You own them purely for the cash flow, not for any hope of appreciation.

• Preferred stock dividends can be suspended if the company’s cash flow doesn’t support them. Bond interest payments cannot. It is easy to check whether a company has ever missed any preferred dividend payments. Many companies have never missed a payment in decades, but we do need to do our homework.

If you would like to have some money in an investment that is more secure than common stock and pays better dividends. and has a higher return than the interest on cash or bonds, consider preferred stocks.

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