The main benefit of owning preferred stock is dividend income. Some preferred shares also include features that can increase total return, and investors may be able to earn capital appreciation.
Preferred stock investors typically buy it for fixed dividend income, which is usually paid quarterly. For example:
An investor purchases 10,000 shares of a 5%, $100 par preferred stock
If the Board of Directors (BOD) approves the dividend, the investor receives $50,000 per year:
Dividend income can be especially useful for investors who want steady cash flow, such as retirees replacing employment income.
It’s important to remember that dividends aren’t guaranteed. The BOD must approve each payment, and the issuer isn’t legally required to pay dividends. Because preferred stockholders take on this extra risk, preferred stock often offers higher yields than debt securities. Interest on debt securities is a legal obligation of the issuer (failure to pay can lead to lawsuits), while dividends are not.
Some preferred stock includes features that can add to your return. In the previous chapter, we discussed participating and conversion features. Both can provide supplemental returns in addition to dividend income.
*Click the link above to review these benefits further.
A capital gain is possible with preferred stock, but it’s generally less likely than with common stock. Preferred stock prices tend to be driven 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, even if the company performs very well. However, an investor may realize (obtain) a capital gain when interest rates fall. As we discussed previously, fixed-income market values have an inverse relationship with interest rates (when one goes down, the other goes up).
Preferred stock is often grouped with fixed-income investments and is generally considered safer than common stock, but it still carries meaningful risks.
Dividend payments require approval from the Board of Directors (BOD). If the corporation is under financial stress, it may skip or indefinitely suspend dividends. Because dividends are not legal obligations of the issuer, preferred stockholders generally have no legal recourse for missed payments.
Also, straight (non-cumulative) preferred shares do not repay skipped dividends.
A corporation in severe financial trouble may file for bankruptcy. In bankruptcy, creditors (third parties the corporation owes money to) may force liquidation if no agreement is reached in 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 stockholders have a higher claim than common stockholders, but they rank below creditors. As a reminder:
Corporate liquidation priority
By the time wages, taxes, and creditors are paid, there’s often little (or nothing) left for stockholders - preferred or common. This is an important risk, especially when investing in an unproven corporation.
Even if a corporation is profitable and pays dividends on time, preferred stockholders face market risks. Interest rate risk occurs when interest rates rise, which typically causes preferred stock prices to fall. We discussed why this happens earlier in this unit.
If an investor sells preferred stock after interest rates rise, they’ll likely realize a capital loss (selling for less than the purchase price).
Falling interest rates generally help preferred stockholders because market prices tend to rise as rates decline. However, lower rates can create reinvestment risk, especially for investors who reinvest dividends.
When interest rates fall, one of two things typically happens:
Either way, when rates fall, reinvested funds tend to earn lower returns.
A call feature allows the issuer to redeem (“take back”) the preferred stock at a specified price. This is a risk to investors and can also increase reinvestment risk.
If the shares are called, the investor may need to reinvest not only dividends, but also the returned principal (par value plus any [call premium]) - often at lower prevailing rates. Issuers typically exercise call features when interest rates fall (to refinance).
In the common stock unit, we discussed 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 may help hedge inflation, but fixed-income investments are more exposed to it.
Let’s reuse the earlier example:
An investor purchases 10,000 shares of a 5%, $100 par preferred stock
This investor receives $50,000 in annual dividends:
$50,000 may provide substantial income today. But if prices rise significantly, that same $50,000 buys less. As the dollar loses purchasing power, the fixed return from investments like preferred stock becomes less valuable. This is why high inflation rates tend to push preferred stock market prices down.
Preferred stock is generally most suitable for investors seeking income. Capital appreciation is less predictable than with common stock and is driven primarily by interest rate changes. Investors focused on growth typically look to common stock (or similar investments).
Convertible preferred stock can offer capital appreciation potential, but the conversion feature is usually considered an added benefit. Dividend income should be the primary reason for investing in preferred stock.
Income-focused investors are often risk averse (they want to avoid risk) and older. However, because dividends can be skipped or suspended, preferred stockholders still face moderate risk levels. Preferred stock is generally less risky than common stock, but riskier than typical debt securities* (e.g., bonds). Investors who don’t want this level of risk may prefer 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 many preferred stockholders invest with a long-term time horizon. Although preferred shares can be callable or sold in the secondary market, investors often hold them for years.
Short-term investors can only collect a limited amount of dividend income and may be forced to sell at a low price if interest rates rise unexpectedly. Longer time horizons allow investors to collect more income over time and better tolerate market price fluctuations caused by interest rate changes.
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