Investing 101: Income investing with preferred stocks

One generally invests in common stocks for capital gains and (hopefully) dividend income. Preferred stocks are all about income. (Usually.) Fourth in a continuing series.

NYSE trading floor.
NYSE trading floor, circa 2008. (Public domain, via Wikipedia)

WASHINGTON, May 31, 2016 – In our previous column, we discussed common stocks: what they are and why you’d invest in them. We also examined the two primary characteristics that often, but not always, make common stocks an appealing investment: the possibility of tax-advantaged capital gains and the frequent (though not universal) payment of quarterly dividends.

Read also: Investing 101: Common stocks, capital gains and dividends

Now we’ll look at another type of stock, not a common stock, but a preferred stock. This class of equities is a rather different animal, but it also can have a place in investment portfolios, particularly in portfolios of super-conservative investors and those who’ve retired or are about-to-retire.

Preferred and cumulative preferred stocks

At first glance, preferred stocks seem to look and feel like common stocks. But they’re very different in behavior and aim. In the first place, at least to the best of our knowledge, preferred stocks do not have voting rights. They are, by nature, rather passive investments. You buy them on the open market for the going price, and they pay you predictable and (almost) never-increasing quarterly dividends to the holder, sometimes theoretically forever.

While having no voting rights, however, preferred stocks do have one major advantage over common stock of the same company: In the event a corporation finds itself in a fiscal pickle, preferred stocks are senior to the common stock of the same company. That means that if corporate accounts have gotten to the point where dividend money is drying up, a company must cut or ultimately eliminate the entire dividend of the common stock first before it moves to cut or eliminate the dividend on the preferred.

In other words, when it comes to the payment or non-payment of dividends, common stock gets nailed first. And then and only then does the preferred stock get a haircut.

But (as those commercials say) wait! There’s more!

There are actually two basic dividend styles in preferred stocks. There are plain old preferred stocks like the ones we’ve just discussed  (correct shorthand plural is “preferreds”); and there are cumulative preferreds.

In regular preferred stocks, if the dividend is eliminated, say, for four or eight quarters before the dividend is resumed—and it must be resumed for a company’s preferred stocks before it’s resumed for its common shares—those dividends you’ve lost in the meantime are gone forever.

Ah, but in a cumulative preferred issue, when the company resumes paying dividends to its cumulative preferred shareholders, it must also pay all the back dividends owed those shareholders in addition to resuming the normal quarterly dividend moving forward.

Thus, assuming a currently wobbly company doesn’t go under entirely and eventually regains its financial health, holders of cumulative preferred shares are made whole again, dividend-wise, while holders of plain old preferred shares… well, too bad, although you will get your scheduled dividends again moving forward. The dividends that weren’t paid are gone.

I took advantage of this phenomenon with some (now-retired) cumulative preferred shares of Ford (symbol: F), buying into currently non-paying Ford cumulative preferred shares about six months in advance of when my investment advisory services predicted the company would resume paying those dividends after recovering, without government assistance, from the disastrous crunch of the Great Recession. When the announcement was made, not only did the cumulative preferred shares jump up substantially in price. I also got all the back dividends that impatient former shareholders missed out on by panicking and selling out when things looked gloomiest, about 3 or 4 years’ worth as I recall. But more on strategy in a later installment.

OK. We have preferred stocks and cumulative preferred stocks. Obviously, if you’re in any of these for the long haul, cumulative preferreds are generally somewhat safer holdings. But I don’t really rule out either kind. You just have to do your homework.

However, there is yet another flavor of preferred stock that may be of even greater interest to investors given the sensitive interest rate climate we’re experiencing in 2016: the term preferred.

Term preferred stocks

Term preferred stocks can be regular or cumulative, although they tend to be the former in my experience. But while regular-style and/or regular cumulative preferred stocks are offered on the market with an open ended term of existence, term preferred stocks actually have a firm expiration date. On that date, the company that issued them redeems these shares at face-value—known as par or par value—plus paying out (usually) the final dividend.

Par is a term that, in general, gets us a little ahead of ourselves, in that it’s usually used to describe bonds. But, if you think about it, a preferred stock is very much like a bond as, unlike shares of common stock, preferred stocks are initially offered on the market at a par value of $25 per share. That’s not a hard and fast rule. I’ve seen par values as low as $10 per share and there are also many preferreds trading today with a par value of $1,000 per share.

But, as with bonds, what that means is this: After a preferred is first sold on the market at the usual par value of $25, it will fluctuate, price-wise, forever or until it is redeemed, again at par value of $25. Bonds function pretty much the same way. But again more later when we talk about bonds.

Why the fluctuation on a product with a fixed dividend? Simple. Even today, interest rates travel up and down, or people think they do. Since a preferred dividend is fixed, the underlying preferred stock’s price fluctuates along with those interest rates.

If interest rates go up, the price of a preferred stock goes down, almost as if the share price on the open market is trying to readjust to reflect the relative value of that fixed dividend. Contrary-wise, if interest rates go down, the price of the preferred goes up, again for essentially the same reason.

If a preferred stock is trading above par value (usually over $25 per share), it’s said to be trading at a premium; whereas, if a preferred stock is trading below par value, it’s said to be trading at a discount.

For term-preferred stocks in particular, this is an important distinction. If you can snag a term-preferred stock at a discount, one that will mature, say, in 2-4 years, you’ll still be paid full or par value for each share you own when it matures, thus giving you a nice, long-term capital gain in addition to those quarterly dividends you got along the way.

I mention this now even though I’m getting a little ahead of myself here. The reason why is that the Fed is very clearly threatening to raise interest rates again, which will invariably smack the prices of all preferreds down to a greater or lesser extent due to that interest rate rule I explained above. But for a term preferred stock, particularly one that matures not too long from now—especially if it’s issued by a strong, reliable company—the hit you take now won’t much matter, because you’ll still be collecting your dividends, AND you’ll get par value just a bit later when the company redeems those shares at par.

That’s why term-preferreds are probably a better buy right now. Personally, I’ve taken a rather large position in one of them, which I’ve described in my Market Maven articles, and which I’ll get back to here a bit later. But just keep this in mind if you’re investing in preferreds.

Convertible and variable rate preferred stocks

There are two additional types of preferred stocks. One you don’t run into very often. The other is starting to become quite fashionable in the current gradually rising interest rate environment. The first additional type of preferred is called a convertible preferred, and no, it has nothing to do with the automotive world. The second type is called a variable rate preferred.

A convertible preferred stock can be, at base, a normal, everyday preferred stock or term preferred. But there’s a kicker: at certain times and under certain conditions, a convertible preferred stock can be “converted” by you into a mathematically-determined number of common shares in the underlying company. Why would you want to do this? If the common stock has been moribund for quite some time but is now starting to make a run for the stars, you might want to trade the income you’re getting for the preferred, and take a theoretically more profitable capital-gains style ride on the common.

By their nature, convertible preferreds trade a little differently from regular preferreds. Since they are convertible to common shares, their price is more or less equally influenced by both prevailing interest rates but also by the price of the common shares. Thus, you’re likely to get a bit more of a ride (volatility) if you invest in this kind of preferred

A variable rate preferred stock is pretty much what its name implies. It’s a preferred stock that starts out with a fixed dividend like any regular old preferred stock. But, at a certain pre-determined point, the dividend rate is cut loose from a fixed rate of return and begins to float quarterly or annually depending on the prevailing interest rate in the open market, a figure frequently based on the LIBOR (the more or less worldwide rate set daily in London) or on the current interest rate of 10-year U.S. Treasuries. All this information is spelled out in the variable rate preferred stock’s prospectus (more on these later), so you need to read the fine print.

Why would you want or would anyone issue a variable rate preferred stock? The answer is fairly simple. In rising interest rate environments (one of which we appear to be entering as we write this), the issuer of this stock knows that investors will likely be attracted to a preferred stock whose rate of return will rise along with interest rates, thus giving them some measure of inflation protection. However, the issuer does also have an ace-in-the-hole if the rate on their variable preferred issue starts getting too high for them. The can (and often do) call the issue. In other words, at their discretion, usually after a given date, they can terminate the issue, pay you your last dividend, and return the original par value back to you.

Indeed, most preferred stocks have such a call provision. But except for term preferreds, that provision is usually only exercised if the issuing company can get a lower effective interest rate (i.e., on the dividend paid) by redeeming a current preferred issue and “refinancing” it by issuing another one but at a lower rate.

There are a few quirky preferreds here and there. I recall one from many years back that was a most unusual variety of convertible preferred stock. It was issued by a mining company and was convertible not into the company’s common stock but into shares of silver bullion.

That said, the types of preferred stocks we’ve discussed here are the ones you’ll usually encounter. Word to the wise: always read up on the terms of a preferred stock that interests you, either by finding its prospectus or by researching the info online. Call dates and provisions, convertibility provisions, rate provisions and maturity dates vary, as do a company’s ability to redeem shares in the event of a takeover or merger by the issuing company. So make sure you know what you’re buying before you buy it.

Bottom line: Preferred stocks are similar to both common stocks and bonds in many ways. They don’t get any votes per share. They are senior to commons shares, but junior to the company’s bonds. They pay a fixed dividend for the life of the stock. And they have various flavors that are more or less “safe” under varying circumstances.

Finally, given the Federal Reserve’s determination to raise interest rates, albeit very slowly, term preferred shares or even variable preferred shares may be a better and/or safer value in current market conditions. Be sure to do your homework.

Next: The (formerly) boring world of corporate and municipal bonds.


Disclaimer: This series of columns is being offered for educational purposes only. The author of this column maintains several active trading and investment portfolios and owns residential and investment real estate.

Any existing or contemplated investment positions mentioned above describe this author’s own investment decisions and should not be construed as either buy or sell recommendations. The current market is highly treacherous and all investors travel at their own risk, so caution should be exercised at all times.  

Illustrations, charts, commentary, and analysis are only the author’s view of current or historical market activity and don’t constitute a recommendation to buy or sell any security or contract. Views, indications, and analysis aren’t necessarily predictive of any future market or government action. Rather they indicate the author’s opinion as to a range of possibilities that may occur going forward.  

References to other reporters, analysts, pundits, or commentators are illustrative only and do not necessarily represent an endorsement of such individuals’ points of view. If specific investment vehicles are mentioned in any article under this column heading, the author will always fully disclose any active or contemplated investments in said vehicles.  

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