Preferred stocks are an important but often misunderstood sector of the financial world, including elements of both equities (stocks) and fixed income (bonds). This tutorial will examine the fundamentals of preferred stocks, including their benefits and drawbacks, types, and who should consider purchasing them. We will use examples to illustrate essential aspects and provide a better understanding for novices.
What Are Preferred Stocks?
Preferred stocks, like common stocks, offer a type of ownership in a firm, but they have distinguishing qualities that give them a unique investment opportunity. The main characteristics of favored stocks are:
Key Characteristics of Preferred Stocks:
- Fixed Dividends: Preferred stocks typically pay fixed dividends on a regular basis. This differs from common stock dividends, which can fluctuate based on the company’s profits.
- Priority in Payments: In the case of liquidation (such as bankruptcy), preferred stockholders get preference over common stockholders in terms of obtaining paid. However, they are subject to bondholders.
- Hybrid Nature: Preferred stocks are a hybrid investment, which means they have characteristics of both stocks (equity) and bonds (fixed income).
- No Voting Rights: Preferred investors, unlike common shareholders, do not have voting rights at shareholder meetings, resulting in less influence over business decisions.
Types of Preferred Stocks
There are various sorts of preferred stocks, each with unique benefits tailored to particular types of investors. Here are the primary types:
1. Cumulative Preferred Stocks:
In cumulative preferred equities, any missed dividend payments compound and must be paid before common stockholders get dividends. This adds added security for investors, guaranteeing they are compensated even if the company experiences difficulties.
Example:
Assume you own 100 shares of cumulative preferred stock with a $5 annual dividend. If the corporation fails to make a dividend payment for a year, the missing payment ($500 total) will accumulate. Prior to paying common investors, the corporation must pay you the accumulated dividend plus the current year’s payout.
2. Non-Cumulative Preferred Stocks:
Non-cumulative preferred stock does not accumulate unpaid dividends. If the corporation fails to pay a dividend, preferred owners forfeit the payment, which cannot be made up later.
Example:
If a corporation fails to pay a $5 dividend on non-cumulative preferred stock, you will lose $5 per share with no remedy for recovery.
3. Convertible Preferred Stocks:
Convertible preferred stocks enable investors to change their preferred shares into a set number of common shares. This option may be helpful if the company’s common stock performs well.
Example:
If you own convertible preferred stocks in a technological firm that permits you to convert each preferred share into ten common shares, and the company’s common stock appreciates significantly, you can convert your preferred stock to common stock and potentially profit from capital gains.
4. Callable Preferred Stocks:
Callable preferred stocks allow the issuing business to “call” or redeem the shares after a set date, typically at a premium to the initial issue price. While this gives the corporation flexibility, it may disadvantage investors if the stock is redeemed when interest rates decline.
Example:
If you acquire callable preferred stocks at $100 per share and the corporation calls them back in two years for $105 per share, you will make a little profit. However, if interest rates fall and the corporation calls the stock, you may have to reinvest with reduced yields.
5. Participating Preferred Stocks:
Participating preferred stocks allow investors to partake in the company’s profits above a specific level. Following their regular payout, participating preferred shareholders may get additional dividends if the firm does exceptionally well.
Example:
You own participating preferred shares in a corporation that pays a fixed $5 dividend per share. If the company performs extraordinarily well and decides to disperse excess profits, you could receive an additional $2 per share on top of the $5 dividend.
Benefits
Preferred stocks provide several compelling benefits for specific sorts of investors, particularly those who value income and stability over high-growth potential.
1. Steady and Predictable Income:
One of the most appealing aspects of preferred stocks is their consistent dividend payments. For income-seeking investors, such as retirees, this can provide a consistent stream of passive income.
Example:
An investor buys 100 shares of a preferred stock that pays a $6 annual dividend. Every year, the investor will get $600 in dividend income, ensuring a consistent income stream. This is more predictable than common stocks, whose dividends might vary depending on the company’s earnings.
2. Priority Over Common Stocks in Liquidation:
In the unfortunate case of a company’s insolvency, preferred owners receive payment before common stockholders, providing some downside protection.
Example:
In the case of bankruptcy, if a corporation has $500,000 in assets but owes $400,000 to bondholders, preferred investors will receive recompense after bondholders. If $50,000 remains, preferred investors will receive that amount proportionally before common stockholders.
3. Less Volatility than Common Stocks:
Preferred equities are less volatile than common stocks and so provide a more reliable investment. While common stock prices might change drastically depending on market conditions, preferred stock prices are usually more stable.
Example:
During a market crisis, preferred stocks may face price fluctuations, but they are usually less severe than common stocks, which can experience rapid falls.
4. Potential for Tax Advantages:
In some areas, dividends from preferred stocks may be taxed at a lower rate than bond interest, giving investors a possible tax advantage.
Example:
In the United States, eligible dividends from preferred stocks are frequently taxed at long-term capital gains rates (lower than regular income tax rates), making them more tax-efficient than bond interest.
5. Convertibility Option:
Some preferred stocks are convertible into common stock, allowing investors to profit from possible stock price increases.
Example:
If you own convertible preferred stocks in a developing technological business and the price of common stock rises, you may decide to convert your preferred shares into common stock, allowing you to capitalize on the upside potential.
Drawbacks
While preferred stocks provide several benefits, they also carry significant risks and limitations that must be carefully examined.
1. Limited Capital Appreciation:
Preferred stocks are intended to give income, not capital growth. While they can increase in value to some amount, they rarely see the same level of price gain as common stocks, particularly in a high-growth environment.
Example:
A ordinary stock in a high-growth technology business may expand in value by 10-20% every year, whereas a preferred stock’s price will likely remain stable with small improvements, which are frequently linked to changes in interest rates and dividend yields.
2. Sensitivity to Interest Rates:
Preferred stocks are sensitive to interest rate fluctuations. When interest rates rise, preferred stocks’ fixed dividends become less appealing, causing their prices to fall.
Example:
If you own preferred stocks that pay a 6% dividend and interest rates rise to 8%, new preferred equities may be issued with an 8% payout. As a result, the market value of your 6% preferred stock may fall because it now provides a lower yield.
3. Inflation Risk:
Fixed dividends gradually lose purchasing power owing to inflation. While you may receive the same dollar amount in dividends year after year, those payments will buy less goods and services as inflation rises.
Example:
If inflation is 3% per year and you receive a $5 dividend per share, the real value of that payout may drop over time, thus eroding your investment’s purchasing power.
4. Subordination to Bonds:
Preferred stockholders are subordinated to bondholders, which means that in the case of liquidation, bondholders will be paid first. If the company experiences financial difficulties, preferred investors may receive nothing if the bondholders’ demands exhaust the company’s assets.
Example:
If a business has $100 million in assets but owes $120 million in bond debt, preferred stockholders will not receive a distribution since the creditors’ claims exceed the total assets.
5. Callable by the Issuer:
Callable preferred stocks can be redeemed by the issuing business, usually when interest rates fall. This can be unfavorable for investors who rely on regular dividend payments.
Example:
If you invest in callable preferred stocks paying a 6% dividend and interest rates fall, the corporation may decide to call the stock and redeem it at the original price. As a result, you risk losing your consistent dividend income and being compelled to reinvest at lower yields.
Who Should Consider Investing in Preferred Stocks?
1. Income-Seeking Investors:
If your primary goal is to create consistent and predictable income, particularly during retirement, preferred stocks can be an excellent choice due to their regular dividends.
2. Conservative Investors:
Investors looking for a mix of risk and return may find preferred stocks interesting because they have lower volatility than regular stocks and higher dividends than bonds.
3. Long-Term Holders:
Preferred stocks are ideal for long-term investors willing to accept moderate capital appreciation in return for consistent income. They are especially handy for individuals who want to diversify their investments.
Who Should Avoid them?
1. Growth-Oriented Investors:
Preferred stocks may not be suited for investors seeking strong capital appreciation because they often lack significant growth potential when compared to common equities.
2. Active Traders:
Preferred stocks are less volatile, making them less appealing to short-term traders who rely on frequent market swings to make money.
3. Those Concerned About Rising Interest Rates:
If you expect interest rates to rise, preferred stocks may be a poor investment because their value may fall as a result of increased market yields.
Conclusion:
Preferred stocks can be a valuable addition to a portfolio for investors looking for consistent income, minimal volatility, and significant tax benefits. However, they carry significant hazards, such as restricted growth potential, interest rate sensitivity, and inflation risk. Understanding the many types of preferred stocks, as well as their pros and downsides, will assist you in determining whether they are a good fit for your financial objectives.
Before plunging into the world of preferred stocks, make sure you understand your financial situation, risk tolerance, and investment goals.
Learn more about preferred stocks and investment strategies from state street global advisors.
