As interest rates continue to be low, where should you search for yield? Should you consider adding preferred stock to your portfolio?
Although the Federal Open Market Committee (FOMC) has gradually been raising its key short-term interest rate since late 2015, interest rates remain historically low. As of mid-August, the 10-year Treasury note yield was roughly 2.26%—not much higher than the 1.7% overall annual inflation figure (and core inflation, for that matter) we saw in July. In other words, investors looking for income that might outpace inflation have faced a challenging environment these last few years.
Low bond yields aren’t exactly new. In fact, they’ve sent some investors scurrying to the stock market to look for returns, helping to push the Dow Jones Industrial Average (DJI) and the S&P 500 Index (SPX) to record highs.
So, where else can one go for potential income?
One place can be preferred stock, says Craig Laffman, director of fixed income trading and syndicate at TD Ameritrade.
A Place for Yield
According to Laffman, 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.
Companies issue preferred stock as another way to raise money. This class of shares acts like a hybrid of bonds and equities.
Preferred stock trades on an exchange like regular stock, but it also offers a dividend that can be fixed. The dividend yield is generally higher than for bonds or common stock dividends, which can be attractive to investors.
Who’s Got Seniority?
Preferred stock is considered a higher class of ownership than common stock. 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.
Let’s look at some of the other implications of preferred shares:
- Preferred shareholder claims are paid out ahead of common shareholders when a company is liquidated.
- They typically carry no voting rights, but common shares usually do.
- They tend to have a higher yield than bonds issued by the same company, because preferred shares are seen as riskier.
- They’re junior to the company’s bonds during a liquidation.
Pros and Cons
Investors should be aware of the benefits and drawbacks of preferred stock, though. Preferred stocks:
- May be issued at lower par value than a bond. This means that investors might have a lower buy-in for preferred shares. For example, most corporate bonds are issued at a par value of $1000, whereas preferred stock might be issued at, say $100 or even $25 a share.
- Often are traded on an exchange. This makes the trading of a preferred stock more similar to common stock versus a traditional bond which generally trades over-the-counter (OTC).
- Tend to not fluctuate in price as much as common stock. That can be a double-edged sword—good for investors if the company’s common shares are tanking, but bad if shares are rallying.
- Are sensitive to fluctuations in interest rates. When interest rates rise, the price of preferred shares typically falls as their yield increases. (Bonds also share this sensitivity to interest rates.) Additionally, companies may have the option to redeem outstanding shares and issue fresh securities. If interest rates decline, a company might think it’s better to call their preferred shares and issue new ones with a lower yield.
Still, preferred stock remains an option even though interest rates are on the rise, Laffman says. That’s because preferred buyers are often looking for the yield they offer.
Buyers of common stock typically want capital appreciation, but buyers of preferred stock are typically looking for income, says Laffman.
Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.
Income Solutions: Hard at Work
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