Preferred stock suitability
Benefits
The benefits of preferred stock are primarily due to the dividends they pay. Additionally, investors may receive those dividend payments with lower tax consequences, certain features may increase return, and investors may even be able to attain capital appreciation.
Cash dividends
The primary benefit of preferred stock is the fixed dividend rate that provides income to investors. As you already know, preferred stock typically makes semi-annual dividend payments to investors. 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 a year in dividends from this investment (5% x $100 par x 10,000 shares). The ability of an investment to provide substantial cash dividends is a huge benefit to investors seeking income, especially those who are retired and looking to replace the income from their former jobs.
While there’s no guarantee that dividend payments will occur, this results in higher rates of return than debt securities. Remember, more risk typically results in higher returns. For an income-seeking investor willing to absorb a little risk in return for higher amounts of income, preferred stock can be a suitable choice.
Lower tax rates
Dividends from stock (common and preferred) are taxed at a lower rate than many other fixed-income securities. Most investors pay a 15% tax on dividends, while those at the highest tax brackets pay 20%. Interest income from bonds is taxed at the investor’s income tax bracket (up to 37%), making dividend tax rates relatively low. This benefits all stock investors, especially those in high tax brackets.
Corporate investors* obtain even more tax benefits than individual investors. Known as the corporate dividend exclusion rule, corporate investors avoid paying taxes on large portions 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:
- 50% of dividends if owning less than 20% of the issuer’s common stock
- 65% of dividends if owning 20% or more of the issuer’s common stock
Corporations typically maintain brokerage accounts where they invest money for the benefit of the company. When this occurs, these corporations end up owning portions of other companies. For example, let’s assume General Electric (GE) owns a small portion of Coca-Cola (KO) stock. If Coca-Cola makes a dividend payment of $100,000 to GE, GE will only pay taxes on $50,000. If GE owned 20% or more of Coca-Cola, they would only pay taxes on $35,000 of the $100,000 dividend payment (65% exclusion).
Another benefit relating to dividends is the “preferred” status preferred stock has over common stock. If the company wants to make a dividend payment to common stockholders, preferred stockholders must be paid prior. If the shares are cumulative, the issuer must additionally make up all prior skipped dividends prior to a common stock dividend disbursement. Preferred stock also maintains priority over common in the event of a liquidation. While they’re below unpaid wages, unpaid taxes, and bondholders, preferred stockholders will receive proceeds from a corporate liquidation prior to common stockholders.
Added features
Other benefits of preferred stock relate to its features. In particular, participating and convertible preferred stock increase the return potential for investors.
If the issuer has a successful year, participating preferred stock is eligible to receive a higher dividend rate than the stated rate. This feature allows the investor to “participate” in the company’s financial success. Non-participating preferred stock pays the same dividend rate, regardless of how well the company performs.
Conversion features provide another way for an investor to obtain a higher return than the stated dividend rate. These preferred shares can convert to common stock of the same issuer, and common stock market values are directly related to the issuer’s success. When a company’s product or service line is successful, the common stock price tends to increase due to higher demand for the company’s common stock. Convertibility provides capital appreciation potential, which is not a typical or significant benefit of non-convertible preferred stock.
Capital gains without added features
While a capital gain is certainly possible with preferred stock, it’s less likely to occur as compared to common stock. Preferred stock market prices are generally influenced by interest rate movements, not the successes of the company. If the shares are not participating or convertible, the dividend rate is fixed and does not change, no matter how well the company performs. In most scenarios, preferred stock does not appreciate in price unless interest rates fall. Interest rate fluctuations are difficult to predict, so investors generally do not expect capital gains from their preferred stock investments.
Risks
While fixed-income investments are generally considered safe (at least safer than common stock), there are numerous risks that investors should be aware of when considering a preferred stock investment.
Skipped dividends
Dividend payments are subject to approval from the Board of Directors (BOD). If the company is struggling financially, it could skip or indefinitely suspend dividend payments. Ultimately, dividend payments are not legal obligations of the issuer. Although it would look bad and may have a long-term negative impact on the issuer’s ability to raise capital in the future, a company can’t share profits if they don’t have any. With no legal recourse for skipped dividends, this is a considerable risk for preferred stockholders. Additionally, if the preferred stock is straight (non-cumulative), the issuer never makes up skipped dividends.
Bankruptcy
If a company’s financial situation gets worse, it may file for bankruptcy. At this point, creditors may force the company to liquidate if a deal can’t be made in bankruptcy court. This results in the company shutting down operations, selling all company assets, and using the proceeds to pay back as many creditors and investors as possible. Preferred stock has a higher priority than common stock, but they’re below everything else. As a reminder:
Corporate liquidation priority
- Unpaid wages
- Unpaid taxes
- Secured creditors
- Unsecured creditors
- Junior unsecured creditors
- Preferred stockholders
- Common stockholders
By the time the company repays unpaid wages, unpaid taxes, and creditors, it’s unlikely there’s anything left for stockholders (preferred or common). This is a risk to consider, especially if investing in a struggling company.
Interest rate risk
Even if a company stays in business and continues to make dividend payments, preferred stockholders are still subject to a number of risks. Preferred stock is subject to interest rate risk, which occurs when interest rates rise. At the beginning of this unit, we discussed why this occurs. If an investor liquidates preferred stock after interest rates rise, it’s quite possible they’ll have a capital loss on the sale (selling the security for less than what it was purchased for).
Inflation (purchasing power) risk
In the last chapter, we discussed the basics of inflation (purchasing power) risk. As a reminder, inflation occurs when general prices of goods and services across the economy rise more than expected. While common stock investments tend to act as a hedge (protection) against inflation, fixed-income investments are very exposed to this risk.
Let’s use an example from the previous section:
An investor purchases 10,000 shares of a 5%, $100 par preferred stock
As we discussed, this investor receives $50,000 in annual dividends (5% x $100 par x 10,000 shares). $50,000 is a considerable amount of money to make on dividends, and many people can live off $50,000 of annual income today. If prices of goods and services across the country begin rising considerably, it becomes more and more difficult to pull off. As the dollar loses purchasing power (costing more money to buy the same thing), the fixed return from investments like preferred stock becomes less valuable. This is why high inflation rates result in falling preferred stock market prices.
Call features
Callable preferred stock also presents a risk to investors. Call risk, which typically occurs when interest rates fall, can result in the investor losing out on a good dividend rate. As you’ve learned, issuers usually call fixed-income securities to refinance and reissue the same security 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.
Interest rates fell and the preferred shares were called in this example. The investor was originally receiving $50,000 in annual dividends (5% x $100 par x 10,000 shares). After the shares were called, they reinvested their funds into a similar set of shares that only provided $30,000 of annual dividends (3% x $100 par x 10,000 shares). This is to be expected 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) are reinvested back into the market at lower rates of return. Many investors prefer to keep as much money invested in securities as possible. When dividends or interest (from bonds) are received, many investors use the funds to purchase new investments. If interest rates fall, it can be assumed the new fixed-income investment will provide a lower rate of return. Even if a preferred stock isn’t called, the investor still experiences this risk with dividends it reinvests back into the market.
Typical investor
Only investors seeking income are suitable for preferred stock. If the investor is only interested in capital appreciation (capital gains), they should probably invest in common stock. Of course, convertible preferred stock offers capital appreciation potential, but the conversion feature is an added benefit, not the primary benefit (the primary benefit is income). From here, we can discuss the nuances.
Investors seeking income are typically risk averse (want to avoid risk). As established by the rule of 100, investors should generally invest more in fixed-income securities the older they get. Therefore, it can be assumed preferred stock investors tend to be older and safer with their investments.
As we already discussed, dividend income is not guaranteed and can be skipped or suspended by the Board of Directors (BOD). Because of this, you can assume investors face moderate risk when they purchase preferred stock. Preferred stock is less risky than common stock, but riskier than your typical debt security (e.g. bonds).
Therefore, the most conservative and risk-averse investors tend to avoid preferred stock, and instead invest their money into safer fixed-income securities like US Government debt. The potential for dividends to stop being paid and/or fluctuations in market price are too much of a risk for this type of investor. If a moderate or fairly conservative investor wanted to take on a little more risk in return for a higher income, preferred stock would be a suitable choice.
Preferred stock does not have a maturity or expiration, so investors should expect to be invested for long periods of time. While it can be callable or sold in the secondary market, most investments in preferred stock last for years. With income as the primary benefit, it takes time to collect a substantial amount of dividends as most shares make semi-annual (twice-a-year) payments. Also, interest rates could rise considerably, driving the market values of preferred shares down. Investors with short-term time horizons might be forced to sell their shares at a low price if this were to occur. Long-term time horizons allow investors to collect dividends over time and to withstand market price fluctuations due to interest rate changes.
Corporations are big investors in preferred stock. As we learned earlier, corporations obtain at least a 50% exclusion on the dividends received from stock investments. If a corporation has money available for investment and is seeking income, preferred stock offers a tax-advantaged investment opportunity.
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