While fixed income investments are generally considered safe (at least safer than common stock), there are risks that investors should be aware of when considering a preferred stock investment.
As we discussed in the previous section, 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.
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
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.
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. In the beginning of this chapter, 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).
Interest rate risk applies to all forms of preferred stock except adjustable-rate preferred stock (ARPS). When interest rates change, the coupons on ARPS adjust similarly. Because of this dynamic, there’s no need for ARPS market values to decline when interest rates rise; their coupons will rise as well.
In the systematic risk section of the common stock chapter, we discussed the basics of inflation (purchasing power) risk. In a nutshell, 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.
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 provide $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.
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