Suitability

Benefits

The primary benefit of owning preferred stock is dividend income. Certain features may also increase returns, and investors may be able to attain capital appreciation.

Cash dividends

Preferred stock investors primarily seek its fixed dividend income, which is typically paid quarterly. 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 receives $50,000 annually (5% x $100 par x 10,000 shares). Dividends can greatly benefit investors seeking income, especially those who are retired and looking to replace the income from their former jobs. While there’s no guarantee dividend payments will be approved, this added risk results in higher rates of return than debt securities. We’ll discuss this in detail later, but interest payments are legal obligations of debt security issuers (they’re sued if payments are not made). As the saying goes, more risk means more returns.

Added features

Certain preferred stock features add additional benefits to this investment. In the previous chapter, we discussed the characteristics of participating and conversion features. Both* can provide supplemental returns on top of dividend income.

*Click the link above to review these benefits further.

Capital gains without added features

While a capital gain is certainly possible with preferred stock, it’s less likely to occur than with common stock. Preferred stock market prices are generally influenced by interest rate movements, not the company’s successes. If the shares are not participating or convertible, the dividend rate is fixed and does not change, no matter how well the company performs. However, an investor may realize (obtain) a capital gain when interest rates fall. As we discussed previously, fixed income market values maintain an inverse relationship with interest rates (when one goes down, the other goes up).

Risks

While fixed-income investments are generally considered safe (at least safer than common stock), there are some risks 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 corporation struggles financially, it could skip or indefinitely suspend dividend payments. Ultimately, dividend payments are not legal obligations of the issuer. With no legal recourse for missed dividends, this is a considerable risk for preferred stockholders. Additionally, straight (non-cumulative) preferred shares never repay skipped dividends.

Bankruptcy

Corporations in dire financial situations may file for bankruptcy. Creditors (third parties the corporation owes money to) could force the business to liquidate if no deal is 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 every other party. As a reminder:

Corporate liquidation priority

1. Unpaid wages
2. Unpaid taxes
3. Secured creditors
4. Unsecured creditors
5. Junior unsecured creditors
6. Preferred stockholders
7. 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 an unproven corporation.

Interest rate risk

Even if a corporation is profitable and makes timely dividend payments, preferred stockholders are subject to other risks. Interest rate risk occurs when interest rates rise, which results in declining preferred stock prices. We discussed why this dynamic unfolds earlier in this unit. If an investor liquidates preferred stock after interest rates rise, they’ll likely experience a capital loss (selling the security for less than what it was purchased for).

Reinvestment risk

Falling interest rates work in favor of preferred stockholders. The further they decline, the higher their market prices rise. However, there is an added risk to be aware of when this occurs. Many preferred stockholders that don’t currently need income choose to reinvest their dividends into new shares. When interest rates fall, one of two things happen. They can expect higher market prices if they buy additional shares in the secondary market, resulting in lower yields on their reinvested money. Or, they can expect lower dividend rates if they buy new shares in the primary market, also resulting in lower yields. Either way, falling interest rates result in reinvested funds attaining lower returns.

Call features

A call feature, which allows the issuer to “take back” an investment for a specified price, is an added risk to the investor. Additionally, it can result in compounded reinvestment risk. Instead of the investor only reinvesting dividends, a call would result in the entire par value (plus any [call premium]) being reinvested likely at lower rates. Remember, issuers typically exercise call features when interest rates fall (to refinance).

Inflation (purchasing power) risk

In the common stock unit, 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 impacted by 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 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 rise considerably, it becomes more difficult to maintain the same standard of living. 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 declining market prices.

Typical investor

Only investors seeking income are suitable for preferred stock. Because capital appreciation is unpredictable and based primarily on interest rate fluctuations, investors seeking growth should consider common stock (or another similar investment). Of course, convertible preferred stock offers capital appreciation potential, but the conversion feature is only an added benefit. Dividend income should be the primary reason a person invests in preferred stock.

Investors seeking income are typically risk averse (want to avoid risk) and older. However, dividend income is not guaranteed and can be skipped or suspended. Therefore, preferred stockholders are exposed to moderate risk levels. It’s less risky than common stock, but riskier than your typical debt security* (e.g. bonds). Investors unwilling to expose themselves to this level of risk should consider safer fixed-income securities like US Government debt.

*We will discuss these securities in great detail later in the Achievable materials. For a preview, click the links above.

Preferred stock has no maturity or expiration, so most preferred stockholders are long-term investors. While it can be callable or liquidated (sold) in the secondary market, most preferred stock investments last for years. Investors with short-term time horizons can only collect so much in dividends and might be forced to sell their shares at a low price if interest rates rise unpredictably. Long-term time horizons allow investors to collect substantial income over time and withstand market price fluctuations due to interest rate changes.