1. Money
Preferred Stock and Individual Investors
The investment that may or may not make sense for your fixed income portfolio

What is Preferred Stock
Preferred stock is a mix between regular common stock and a bond.  Each share of preferred stock is normally paid a guaranteed, relatively high dividend and has first dibs over common stock at the company's assets in the event of bankruptcy.  In exchange for the higher income and safety, preferred shareholders miss out on large potential capital gains [or losses].  Owners of preferred stock generally do not have voting privileges.

The terms of preferred shares can vary widely, even when issued by the same company.  For instance, here is a list of some of the different kinds of preferred stock that are available to investors:

Adjustable rate preferred stock
Convertible preferred stock
First preferred stock
Participating preferred stock
Participating convertible preferred stock
Prior Preferred Stock
Second Preferred Stock

How do preferred shares respond to moves in the common stock?
If a large drug companies discovered a cure for the common cold, the stock would go through the roof in anticipation of the tens of billions of dollars the company could 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 large dividend checks.  Two weeks later, the company announces that the cure does not work, and the common stock plummets to the ground, destroying investor's portfolios.  What happens to the drug company's preferred shareholders?  Not much; as long as the business is still making those dividend payments, they haven't lost a dime.

If you own convertible preferred shares [a special kind of preferred stock], the value of the shares is closely tied to the price of the common stock.  Convertible "percs" as their known, give the owner of each share of preferred stock the right to 'convert' that share into common stock at some point in the future based on different criteria, including the price of the common.

Should I invest in shares of preferred stock?
In many ways, the insulation preferred stock gives shareholders can seem to be very 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 corporate bonds when rates are attractive enough.

Copyright © 2002 Joshua Kennon

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