The benefits of preferred stock mainly come from the dividends it may pay. In addition, those dividends may be taxed more favorably than bond interest, certain features can increase an investor’s return, and some preferred shares may offer limited capital appreciation.
The primary benefit of preferred stock is its fixed dividend rate, which is designed to provide income.
Preferred stock typically pays dividends semi-annually. For example:
An investor purchases 10,000 shares of a 5%, $100 par preferred stock
If the Board of Directors (BOD) declares the dividend, the investor will receive $50,000 per year in dividends:
This income potential is a key benefit for investors who want cash flow, such as retirees replacing employment income.
Dividend payments are not guaranteed, but preferred stock often offers higher income potential than debt securities. That higher income comes with higher risk - generally, more risk means the potential for higher return. For an income-focused investor who can accept some risk in exchange for higher income, preferred stock may be a suitable choice.
Dividends from stock (common and preferred) are generally taxed at a lower rate than interest from many fixed-income securities. Most investors pay 15% tax on dividends, while investors in the highest tax brackets pay 20%. By contrast, interest income from bonds is taxed at the investor’s ordinary income tax bracket (up to 37%). This makes dividend tax rates relatively low, especially for investors in higher brackets.
Corporate investors may receive even greater tax benefits. Under the corporate dividend exclusion rule, corporations can exclude a portion of dividends they receive from taxation. In particular:
Corporations can avoid paying taxes on the following:
Corporations often invest through brokerage accounts for the benefit of the company, which can result in owning shares of other companies. For example, assume General Electric (GE) owns a small portion of Coca-Cola (KO) stock. If Coca-Cola pays a dividend of $100,000 to GE, GE will pay taxes on only $50,000 (a 50% exclusion). If GE owned 20% or more of Coca-Cola, it would pay taxes on only $35,000 of the $100,000 dividend (a 65% exclusion).
Another dividend-related benefit is the “preferred” status preferred stock has over common stock:
Preferred stock also has priority over common stock in liquidation. Although preferred stockholders rank below unpaid wages, unpaid taxes, and bondholders, they receive liquidation proceeds before common stockholders.
Other benefits of preferred stock come from specific features. In particular, participating and convertible preferred stock can increase an investor’s return potential.
If the issuer has a strong year, participating preferred stock may receive a dividend higher than the stated rate. This allows the investor to “participate” in the company’s financial success. Non-participating preferred stock pays the same dividend rate regardless of company performance.
Conversion features provide another way to potentially earn more than the stated dividend rate. Convertible preferred shares can be converted into the issuer’s common stock. Because common stock prices tend to rise when the issuer performs well and demand increases, convertibility can add capital appreciation potential - a benefit that is not typical (or significant) for non-convertible preferred stock.
Capital gains are possible with preferred stock, but they’re generally less likely than with common stock. Preferred stock prices are usually influenced more by interest rate movements than by the company’s business success.
If the shares are not participating or convertible, the dividend rate is fixed and doesn’t change, no matter how well the company performs. In most scenarios, preferred stock doesn’t rise in price unless interest rates fall. Because interest rate movements are difficult to predict, investors typically don’t buy preferred stock expecting capital gains.
Although fixed-income investments are often viewed as safer than common stock, preferred stock still carries several important risks.
Dividend payments require approval from the Board of Directors (BOD). If the company is under financial stress, it may skip or suspend dividends indefinitely. Dividends are not a legal obligation of the issuer.
Even though skipping dividends can harm the issuer’s reputation and make it harder to raise capital later, a company can’t distribute profits it doesn’t have. Because preferred stockholders generally have no legal recourse if dividends are skipped, this is a significant risk. If the preferred stock is straight (non-cumulative), the issuer never has to make up skipped dividends.
If a company’s financial condition worsens, it may file for bankruptcy. Creditors may force liquidation if the company can’t reach an agreement in bankruptcy court. Liquidation means the company shuts down operations, sells its assets, and uses the proceeds to repay creditors and investors in order of priority.
Preferred stockholders have priority over common stockholders, but they rank below most other claims. As a reminder:
Corporate liquidation priority
By the time unpaid wages, unpaid taxes, and creditors are paid, there may be little or nothing left for stockholders (preferred or common). This is an important risk, especially when investing in a financially weak issuer.
Even if the company remains in business and continues paying dividends, preferred stockholders face interest rate risk. This risk occurs when interest rates rise. Earlier in this unit, we discussed why this occurs.
If an investor sells preferred stock after interest rates rise, the investor may realize a capital loss (selling the security for less than the purchase price).
In a previous chapter, we discussed the basics of inflation (purchasing power) risk. Inflation occurs when the general prices of goods and services across the economy rise more than expected. While common stock may act as a hedge against inflation, fixed-income investments are more exposed to this risk.
Using the earlier example:
An investor purchases 10,000 shares of a 5%, $100 par preferred stock
This investor receives $50,000 in annual dividends:
$50,000 can be meaningful income today. However, if prices rise significantly, that same $50,000 buys less over time. As the dollar loses purchasing power, the fixed income from preferred stock becomes less valuable. This is why higher inflation rates tend to push preferred stock market prices down.
Callable preferred stock adds another risk: call risk. Call risk typically shows up when interest rates fall and the issuer calls the shares, which can cause the investor to lose a favorable dividend rate. Issuers often call fixed-income securities to refinance and reissue at lower rates.
An investor owns 10,000 shares of a 5%, $100 par callable preferred stock. Interest rates fall to 3% and the issuer calls the shares at par. The investor reinvests the proceeds back into another set of preferred stock with a comparable risk profile and buys 10,000 shares of a 3%, $100 par preferred stock.
In this example, the investor’s annual dividend income drops:
This is a typical outcome when interest rates fall. The investor is experiencing call risk, which is the worst form of reinvestment risk.
Reinvestment risk occurs when proceeds from an investment (typically dividends or interest) must be reinvested at lower rates of return. Many investors reinvest dividends or bond interest to keep funds invested. When interest rates fall, new fixed-income investments generally offer lower returns. Even if preferred stock isn’t called, an investor can still face reinvestment risk when reinvesting dividend payments.
Preferred stock is generally suitable for investors who want income. If an investor’s primary goal is capital appreciation (capital gains), common stock is usually a better fit. Convertible preferred stock can offer capital appreciation potential, but the conversion feature is an added benefit - not the primary reason most investors buy preferred stock.
Income-focused investors are often risk averse (they prefer to avoid risk). Based on the rule of 100, investors typically allocate more to fixed-income securities as they get older. For that reason, preferred stock investors are often older and more conservative.
At the same time, preferred stock dividends are not guaranteed and can be skipped or suspended by the Board of Directors (BOD). Because of this, preferred stock is generally considered a moderate risk investment: less risky than common stock, but riskier than typical debt securities (e.g., bonds).
As a result, the most conservative investors often avoid preferred stock and instead choose safer fixed-income securities like US Government debt. For these investors, the possibility of skipped dividends and market price fluctuations may be too much risk. A moderate or fairly conservative investor who wants higher income and can accept additional risk may find preferred stock suitable.
Preferred stock has no maturity or expiration date, so investors should expect to hold it for long periods. Although shares may be callable or sold in the secondary market, many preferred stock investments last for years. Since income is the primary benefit, it often takes time to collect substantial dividends, especially because most shares pay semi-annually.
Interest rates may also rise significantly, which can reduce the market value of preferred shares. Investors with short time horizons may be forced to sell at a low price if this happens. Longer time horizons allow investors to collect dividends over time and better tolerate price fluctuations caused by interest rate changes.
Corporations are also major investors in preferred stock. Because corporations receive at least a 50% exclusion on dividends from stock investments, preferred stock can be a tax-advantaged income investment when a corporation has funds available to invest.
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