Preferred Stock: An Investment Opportunity to Consider

For income investors, preferred stock may be worth considering, especially given the recent increase in interest rates and higher yields now available on preferred stock. Investors looking at preferred stock will find choices, for example, among many well-known banks, utilities and real estate companies that issue preferred stock to raise additional long-term capital to complement their bonds and common stock.

What you need to know about investing in preferred stocks.

How is preferred stock different from bonds and common stock?

Bondholders are the first to be paid off if there is any value left after a company is liquidated when it goes bankrupt. After bondholders are paid, if there is still any money left, preferred stockholders are paid. Only then, any money still available would be distributed to common stockholders.

Therefore, all other things being equal, preferred stock is riskier than investing in the bonds but safer than investing in the common stock of a particular company. This “middle” position means preferred stock usually gets a higher fixed dividend1 than the coupon on the company’s bonds, but has a lower expected total investment return than the company’s common stock.

The company’s board of directors must approve each preferred dividend, just like the board has to approve each common stock dividend. In contrast, failure to pay bond interest triggers a default with implications that may threaten the company’s existence. During financial stress, preferred stock dividend payments may be skipped without such possibly grave implications. Despite this, many preferred stock issuers are large, stable companies whose preferred dividends are reliable and safer than their common stock dividends.

Adding to their appeal, preferred dividends may receive more favorable tax treatment for investors. Preferred dividends may be taxed at the lower dividend income tax rate vs. the higher interest income tax rate.2

To be sure, the long-term nature of preferred stock means, due to interest rate changes, the value of a company’s preferred stock can be more volatile than the value of shorter-term bonds of the company. But, preferred stock usually includes a call feature, meaning the company can redeem the preferred stock perhaps many, many years before its maturity date. If the dividend is high enough and the call date is not too far in the future, this call date may be practically considered to be the maturity date. This is because the company would likely redeem this high dividend preferred as soon as it can and then maybe issue new, lower dividend preferred stock. In these cases, the value of the high-dividend preferred stocks of quality issuers may not be that sensitive to interest rate changes.

Why is preferred stock worth considering today?

This summer, along with the economic pessimism triggered by the Brexit, the yield on the 10-year US Treasury fell to about 1.35%. Recently, the economic optimism triggered by the US election pushed the yield on the 10-year Treasury to about 2.35%. Preferred stocks in this higher interest rate environment had price declines of 10% to 15% in many cases. For example, many $25-par preferred securities have fallen from around $28 to less than $25 per share. This recently led to dividend yields on many preferred stocks going to the 6% to 8% range from the 4% to 6% range.3 Interestingly, this increase is much more than the increase in market interest rates.

At the same time, a potentially more favorable environment for banks, many of which are preferred issuers, produced gains of upwards of 20% for their common stocks. Banks are expected to benefit from higher interest rates and more favorable regulation. Bank of America, for example reports “its net banking revenue would increase by $5.3 billion on an annualized basis if short- and long-term rates both moved up by 1 percentage point.”4 Thus, many preferred stocks could be perceived a safer investment now despite the big drop in the prices of many preferred shares.

Investors may consider individual preferred shares. Alternatively, preferred stock mutual funds and ETFs can provide efficient diversification and easier execution, and perhaps more straightforward year-end accounting and tax reporting.2 (Since individual preferred stock usually trades much less frequently and with less liquidity than the same issuer’s common stock, investors should consider limit orders when executing preferred stock trades.)

Thus, with the 6% to 8% yields now available on many preferred stocks being much more conducive to meeting some investors’ income goals, and the expected improving outlook for many preferred issuers, it may be sensible to consider preferred stock as part of a diversified investor’s portfolio.

1 Some preferred shares offer a fixed-rate dividend for several years, which then converts to a floating-rate dividend.
2 Please consult your tax and accounting advisor.
3 Like bonds, when prices on preferred stock falls, yields rise.
4 http://www.wsj.com/articles/why-bank-investors-are-predicting-a-trump-windfall-1478814691

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