While fixed income investments are generally considered safe (at least safer than common stock), there are still risks to understand before investing in preferred stock.
As discussed in the previous section, dividend payments must be approved by the Board of Directors (BOD). If the company is struggling financially, it may skip or indefinitely suspend dividend payments. Dividend payments are not legal obligations of the issuer.
Skipping dividends can damage 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 when dividends are skipped, this is a significant risk.
Additionally, if the preferred stock is straight (non-cumulative), the issuer does not make up skipped dividends.
If a company’s financial condition continues to deteriorate, it may file for bankruptcy. In bankruptcy, creditors may force the company to liquidate if a deal can’t be reached 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 stock has a higher claim than common stock, but it ranks below creditors. As a reminder:
Corporate liquidation priority
By the time unpaid wages, unpaid taxes, and creditors are paid, there’s often little or nothing left for stockholders (preferred or common). This is an important risk to consider, especially when investing in a financially weak company.
Even if the company remains in business and continues paying dividends, preferred stockholders are still exposed to market risks. Preferred stock is subject to interest rate risk, which occurs when interest rates rise. Earlier in this chapter, we discussed why this occurs.
If an investor sells preferred stock after interest rates rise, the market price may be lower than the purchase price, resulting in a capital loss.
Interest rate risk applies to all forms of preferred stock except adjustable-rate preferred stock (ARPS). When interest rates change, ARPS dividend rates adjust as well. Because the dividend rate can rise when rates rise, ARPS market values don’t need to decline in the same way fixed-rate preferred stock often does.
In the systematic risk section of the common stock chapter, we covered the basics of inflation (purchasing power) risk. Inflation occurs when the general prices of goods and services across the economy rise more than expected.
Common stock often provides some protection against inflation because earnings and dividends may rise over time. Fixed-income investments, including preferred stock, are more exposed because their payments are typically fixed.
Let’s use an example from the previous section:
An investor purchases 10,000 shares of a 5%, $100 par preferred stock
This investor receives $50,000 in annual dividends (5% x $100 par x 10,000 shares). If prices across the economy rise significantly, that same $50,000 buys less than it used to. As the dollar loses purchasing power, the fixed dividend from preferred stock becomes less valuable in real terms. This is why high inflation rates are often associated with falling preferred stock market prices.
Callable preferred stock introduces another risk: call risk. Call risk typically increases when interest rates fall, because issuers often call fixed-income securities to refinance and reissue them 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 was originally receiving $50,000 in annual dividends (5% x $100 par x 10,000 shares). After the shares are called, the investor reinvests in similar preferred stock but now receives only $30,000 in annual dividends (3% x $100 par x 10,000 shares). This reduction in income is the practical impact of call risk.
Call risk is closely related to reinvestment risk, and it’s often considered 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 a preferred stock isn’t called, an investor can still face reinvestment risk when reinvesting dividend payments.
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