1. Money

The Many Flavors of Preferred Stock

A Possible Investment for your Fixed Income Portfolio

By

Preferred stock is a hybrid between common stock and a bond. Each share of preferred stock is normally paid a guaranteed dividend which receives first priority (i.e., the common stockholders cannot receive a dividend until the preferred dividend has been paid in full) and has dibs over the common stockholders at the company's assets in the event of bankruptcy (its claim is still subordinate to that of the bond holders, however). In exchange for the higher income and perceived safety, preferred shareholders forgo the possibility of large capital gains.

The terms of preferred stock issues can vary widely, even among the same corporation. Arguably, the most important characteristic of a preferred stock is if it is cumulative or non-cumulative. In a cumulative issue, dividends that are not paid (referred to as "in arrears") build up. Before any dividend can be paid on the common stock, the entire in arrears balance must be paid in full. If a preferred issue is non-cumulative and a dividend payment is missed, the shareholders are out of luck; they will, most likely, never receive that money from the company even if and when the enterprise encounters prosperous times.

There are a number of additional provisions that can affect the value of a preferred stock. Here are just a few:

 

  • Voting vs. Non-Voting: Owners of preferred stock may or may not have voting rights. There have been cases in the history wherein preferred shares only received voting rights if dividends had not been paid for a stipulated length of time. Such a provision effectively puts the preferred shareholders in the position of a first mortgage bond holder by giving them the collective power to enforce payment on their claim, resources permitting.

     

  • Adjustable rate preferred stock: Holders of the preferred stock receive a dividend that differs based on any number of factors stipulated by the company at the issue's initial offering.

     

  • Convertible preferred stock: Holders of this type of security have the right to convert their preferred stock into shares of common stock. This allows the investor to lock in the dividend income and potentially profit from a rise in the common stock while being protected from a fall in the same.

     

  • Participating preferred stock: Normally, shares of this type of preferred stock receive a set dividend plus an additional dividend based upon a stipulated percentage of either the net income or the dividend paid to the common stock holders.

The variations are endless. It is quite possible an investor could come across a non-voting cumulative participating convertible preferred issue. Due to the individuality of the preferred stock field, we must stick to generalizations.

 

How do preferred shares respond to moves in the common stock?

If a large drug company discovered a cure for the common cold, the common stock would go through the roof in anticipation of the tens of billions of dollars the shareholders expect to earn in the future. At the same time, the company's preferred shares probably wouldn't budge much in price. The preferred shareholders would have missed out on the huge capital gains, albeit while collecting dividend checks. If, two weeks later, the company announced that the cure is not effective, the common stock would plummet. What happens to the company's preferred shareholders? Not much as long as the business is still making the respective dividend payments, they haven't lost a dime.

If, however, the investor had owned convertible preferred shares in this scenario, the price of convertible "percs", as they're known, would have experienced a tremendous rise and fall based on the expected profit an investor could have realized by converting his shares into common stock. As long as the holder of the preferred did not convert his shares or acquire more preferred at the inflated price, he would experience no loss of principal. (Perhaps now is the time to repeat the old Wall Street maxim, "never convert a convertible stock".)

 

Should I invest in shares of preferred stock?

In many ways, the insulation preferred stock appears to offer shareholders can seem attractive. The truth is, preferred stock probably doesn't make much sense for individual investors; however, it can be a goldmine for corporate portfolios. Why? Federal tax laws only require companies to pay income tax on 30% of their preferred dividends, meaning a full 70% is essentially tax-free! Individual investors, on the other hand, have to pay taxes on the full dividend received. Your portfolio will probably receive a higher after-tax yield by investing in corporate bonds when rates are attractive enough or municipal bonds if you are in a higher tax bracket. Equally as important, however, is the fact that you will likely receive a senior claim in such investments as opposed to the subordinate position offered by most preferred stocks.

 

Read More About Investing in Stock or Bonds

You can find more information about investing in stock in our Complete Guide to Investing in Stock.  You might also want to check out 3 Bond Strategies for Long-Term Investors.

©2014 About.com. All rights reserved.