The benefits of preferred stock mainly come from the dividends it pays. In some cases, those dividends may be taxed more favorably than interest income, certain features can increase an investor’s return, and investors may also be able to earn capital appreciation.
The primary benefit of preferred stock is its fixed dividend rate, which provides income to investors. Preferred stock typically pays dividends semi-annually. For example:
An investor purchases 10,000 shares of a 5%, $100 par preferred stock
As long as the Board of Directors (BOD) approves the payment, this investor will receive $50,000 per year in dividends (5% × $100 par × 10,000 shares).
This income potential can be especially attractive to investors who want steady cash flow, such as retirees replacing employment income.
Dividend payments aren’t guaranteed, but that added uncertainty is one reason preferred stock often offers higher income rates than debt securities. In general, taking on more risk can lead to higher expected returns. 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 lower rates than interest from many fixed-income securities. Most investors pay a 15% tax on dividends, while those 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 tax brackets.
Corporate investors* may receive even greater tax benefits than individual investors. Under the corporate dividend exclusion rule, corporate investors can exclude (avoid paying taxes on) a large portion of dividends they receive.
*This rule only applies to corporations structured as C-corps and does not apply to S-corps or any other business form. Various business structures are discussed later in this material.
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 $100,000 dividend to GE, GE will pay taxes on only $50,000. 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. If a company pays a dividend to common stockholders, it must pay preferred stockholders first. If the shares are cumulative, the issuer must also make up all previously skipped dividends before paying any common stock dividends.
Preferred stock also has priority over common stock in a 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 dividends above the stated rate. This allows the investor to “participate” in the company’s financial success. By contrast, 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 a company performs well (as demand for the stock increases), convertibility can add capital appreciation potential. This is not typically a meaningful benefit of 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 operating 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 many cases, preferred stock prices rise mainly when interest rates fall. Because interest rate movements are difficult to predict, investors typically don’t rely on preferred stock for capital gains.
Although fixed-income investments are often considered 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 dividend payments. Dividends are not legal obligations of the issuer.
Skipping dividends can harm the issuer’s reputation and make it harder to raise capital in the future, but a company can’t distribute profits it doesn’t have. Because preferred stockholders generally have no legal recourse for skipped dividends, 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 stops operating, sells its assets, and uses the proceeds to repay creditors and investors based on priority.
Preferred stock has higher priority than common stock, but it ranks below most other claims. As a reminder:
Corporate liquidation priority
After paying wages, taxes, and creditors, there’s often 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 sale may result in a capital loss (selling for less than the purchase price).
In the last chapter, we discussed the basics of inflation (purchasing power) risk. Inflation occurs when general prices of goods and services across the economy rise more than expected. Common stock often provides some protection against inflation, but fixed-income investments are more exposed.
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 (5% × $100 par × 10,000 shares). That may be enough income to live on today, but 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 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 force the investor to give up a higher dividend rate.
Issuers often call fixed-income securities to refinance - redeeming the existing security and reissuing a similar one at a lower rate.
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 from $50,000 (5% × $100 par × 10,000 shares) to $30,000 (3% × $100 par × 10,000 shares). This is a typical outcome when interest rates fall. The investor is experiencing call risk, which is the most severe 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 stay fully invested. When interest rates fall, new fixed-income investments generally offer lower returns. Even if preferred stock isn’t called, reinvesting dividend payments can still expose the investor to reinvestment risk.
Preferred stock is generally suitable for investors who primarily seek income. If an investor’s main goal is capital appreciation (capital gains), common stock is often a better fit. Convertible preferred stock can offer capital appreciation potential, but that conversion feature is an added benefit rather than the primary reason investors buy preferred stock.
Income-focused investors are often risk averse (they prefer to avoid risk). Under the rule of 100, investors generally allocate more to fixed-income securities as they get older. As a result, preferred stock investors are often older and tend to invest more conservatively.
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 typically considered a moderate risk investment: less risky than common stock, but riskier than typical debt securities (e.g., bonds).
For that reason, the most conservative investors often avoid preferred stock and instead choose safer fixed-income securities such as US Government debt. For these investors, the possibility of suspended dividends and market price fluctuations may be too much risk. However, for a moderate or fairly conservative investor willing to accept somewhat higher risk in exchange for higher income, preferred stock can be a suitable choice.
Preferred stock has no maturity or expiration date, so investors should generally 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.
Because income is the primary benefit, time matters: it takes time to collect substantial dividends, especially when payments are semi-annual (twice per year). Also, interest rates can rise significantly, which can push preferred stock prices down. Investors with short time horizons may be forced to sell at a low price if rates rise. 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. As discussed earlier, corporations may receive at least a 50% exclusion on dividends received from stock investments. If a corporation has funds available and wants income, preferred stock can provide a tax-advantaged opportunity.
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