Preferred Stock: A Potential Income Tool in Your Toolbox

Although interest rates have risen from historic lows, Treasuries are still not yielding very much by historical standards, which could be one reason the stock market has been grinding upwards.

But let’s say you’re a little worried about high valuations in equities and would like to introduce some investments into your portfolio that potentially provide a bit more safety than common stock while also paying a yield that’s typicially higher than those in the Treasury market.

Though that type of safety-oriented yield hunting may seem like a contradiction in terms, it doesn’t necessarily have to be for investors who consider preferred stock. It might make sense to buy preferred shares if you want to use the equity market to get yield, but you don’t want to use common stock of traditional high-yield companies, according to Craig Laffman, director of fixed-income trading and syndicate at TD Ameritrade.

A quick scan of preferred issuance at QuantumOnline.com shows there are plenty of well-known companies with solid ratings from Moody’s and Standard & Poor’s that were recently yielding more than 4%. Not too shabby; the rate on the 10-year Treasury was recently around 1.5%—though it should be noted that Treasuries are backed by the full faith and credit of the U.S. government.

What Is Preferred Stock?

Companies issue preferred stock as another way to raise money. Most corporate capital structures include senior secured debt, senior debt, subordinated debt, preferred stock, and common stock. Investors get paid in that order in the event the company goes bankrupt and is liquidated—assuming there’s anything left for holders of preferred and common stock.

Preferred stocks behave like a hybrid investment with characteristics of common stocks and bonds. The price of preferred shares fluctuates but is typically less than common stock. And similar to a bond, a preferred stock regularly pays income. The difference is that preferred stocks pay income in the form of a dividend, whereas bonds pay interest and the return of principal at maturity.

Preferred stock is sensitive to fluctuations in interest rates. Similar to bonds, when interest rates rise, the price of preferred shares typically falls as their yields increase. But when interest rates fall, preferred shares become worth more.

Typically, preferred shares don’t realize the same type of capital appreciation that common stocks do when, say, a company reports blowout earnings. Rather, with preferred stock, the yield is your return.

“Buyers of common stock typically want capital appreciation, but buyers of preferred stock are typically looking for income,” Laffman noted.

Of note, while common shares typically come with voting rights, preferred shared usually don’t. If you’re the type who’s diligent about filling out those proxy cards, remember that, with preferred stock, you’ll likely not have the opportunity to vote your shares.

What Are the Benefits of Preferred Stock?

Comfort level. Because investors can enter a ticker symbol (symbols often include a letter describing the series, such as XYZ-A) and trade preferred shares in a self-directed manner, preferred stock can have a more familiar feel to investors unaccustomed to trading fixed-income securities. Traditional bonds generally trade over the counter (OTC).

Lower buy-in. Most corporate bonds are issued at a par value of $1,000, whereas preferred stock might be issued at $100 or even $25 per share.

Some seniority. Preferred shareholders’ claim on company assets and earnings is senior to that of common shareholders—which means that companies have a greater obligation to pay preferred dividends than dividends on common stock.

What Are the Risks of Preferred Stock?

Lower seniority than bondholders. If a company goes into bankruptcy and ends up getting liquidated, bondholders get paid before preferred shareholders, which is why preferred shares tend to yield more.

Low liquidity. With some preferred stocks trading only a few thousand shares per day, low liquidity can be a risk if you want to sell your shares. And you may not get as good of a price because preferred stocks can have wide spreads between bid and ask prices.

Bottom Line on Preferred Stock

Preferred shares can offer an avenue for income investors wanting more yield than either corporate or government bonds. At the same time, these shares allow people to buy into an investment that offers a bit more safety than common stock.

For investors focused on income, “this is a product worth looking at,” Laffman said.

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Payment of stock dividends is not guaranteed and dividends may be discontinued. The underlying stock is subject to market and business risks including insolvency.