Lessons from the Pros

Proactive Investor

Preferred Stocks – How to Choose?

In our previous article, Have You Considered Preferred Stocks, we discussed U.S. preferred stocks as an investment idea. As a conservative income-generating instrument, preferred stocks have a lot to offer. Their reason for being is to pay dividends. Dividend yields for investment-grade preferred stocks are now in the mid 6 to over 8%, and sometimes even higher. On lower-rated preferreds, yields are higher still. Preferred stock prices are much less volatile than common stock prices, though they do fluctuate more than bond prices. And some preferred shares have preferential tax treatment.

The preferred stock world is pretty diverse – at last count, almost 500 different preferred stocks were available, issued by all kinds of companies. The biggest issuers of preferred stock are banks; REITs and utilities are also big users. There are quite a few web sites that are dedicated to preferred stocks, so research is not hard to do.

4 Criteria for Choosing Preferred Stocks

For individual investors interested in preferred stocks, a few selection criteria can help you narrow down the list of candidates:

1. Credit rating.

Many issuers of preferred shares have credit ratings assigned by the same rating agencies that rate bonds – Moody’s and Standard and Poor’s. A Standard & Poor’s ratings of BBB- or better, or a Moody’s rating of Baa3 or higher are considered Investment Grade, meaning there is a low risk of default. Below are the rating scales:

Preferred Stock Ratings Tier
Moody’s S&P Rank
Aaa AAA 1 Investment Grade
Aa1 AA+ 2
Aa2 AA 3
Aa3 AA- 4
A1 A+ 5
A2 A 6
A3 A- 7
Baa1 BBB+ 8
Baa2 BBB 9
Baa3 BBB- 10
Ba1 BB+ 11 High-Yield (Junk)
Ba2 BB 12
Ba3 BB- 13
B1 B+ 14
B2 B 15
B3 B- 16
Caa1 CCC+ 17
Caa2 CCC+ 18
Caa3 CCC- 19
Ca CC 20
C C 21
NR NR 22 Not Rated

Interestingly, not all preferred stock issuers have their shares rated. Less than half have any ratings at all. Banks, which are the largest issuers of preferred stock, almost never submit their preferred shares for ratings. Not having a credit rating doesn’t necessarily mean that the preferred stock is a bad risk – but it does mean that you have no way of knowing. If you are concerned about the safety of your investment, sticking to preferred shares rated investment grade is a good place to start.
2. Cumulative Dividends
Some preferred stock shares are cumulative – meaning that if the issuer misses a dividend because of insufficient cash flow, they must make it up later. However, not all issues are cumulative – only about two out of three. During the 2008 financial crisis, many banks suspended their dividends for many months and were not required to make them up.

Taken together, narrowing down the entire preferred stock universe to those issues that are both investment grade and cumulative cuts down the population to under 180 issues – a manageable number to evaluate.
3. Liquidity
Free Trading WorkshopLiquidity of the preferred shares can be an issue. Because preferred shares are more thinly traded than common shares, the spread between the Bid and Ask prices can be large. For individual investors, who generally buy at the Ask price and eventually sell at the Bid price, the bid-ask spread is a cost of owning the shares. Even though you may have no intention of selling the preferred shares you buy today any time soon, you will eventually incur the spread. It is not uncommon for the spread to exceed a year’s worth of dividend income. A precious few preferred issues have bid-ask spreads of less than two quarters’ worth of dividends. It is easy to observe the bid-ask spread of any preferred issue you are thinking of buying within your online trading platform.
4. Qualified or non-qualified dividends
For investors who plan to hold preferred shares in a taxable (non-IRA) account, the qualified nature of many preferred stock dividends is important. For those preferreds whose dividends are qualified (which are most preferreds issued by companies other than REITS), the dividends are taxed at the investor’s long-term capital gains tax rate, rather than their ordinary income tax rate as bond interest income would be.

Filtering preferred stock shares by all of these criteria: credit ratings. cumulative vs non-cumulative, liquidity and qualification of the dividends, will narrow down your search to a handful of candidates. Choose them well, and preferred shares can reward you with years of stable income at high rates.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

Join over 170,000 Lessons from the Pros readers. Get new articles delivered to your inbox weekly.