Is High-Yield Preferred Stock Right for You?

In looking for income investments, preferred stock can be a good choice.

May 29, 2015 at 3:03PM

Many investors go out of their way to find the highest yields from their investments. Yet many investors never look at high-yield preferred stock as an alternative to other income-oriented options. Let's take a closer look at preferred stock to see if it's right for you.

What is preferred stock?
A preferred stock is stock that has certain rights which are senior to common stock. This may be in the payment of dividends or the liquidation of assets.

In the hierarchy of claims upon a company's assets and earnings, common stock is at the bottom. To compensate, it gets the right to vote at annual meetings, elects the board of directors, etc. Preferred stock has a higher claim that must be satisfied before the claim of common stock may be satisfied. This can be in the form of dividends which are paid first to preferred stock, and then to common stock. Preferred stock usually has no voting right. Debt (bank loans to the company and bonds) has a higher claim, still. Depending on the terms of the issue (a company can issue several different types or "series" at different times), the preferred stock may or may not include any of the following:

- Preference in the payment of dividends (usually present)

- Dividends are often cumulative. That is, if they are not paid in a given year, they accumulate and are owed in future years.

- Claim on liquidation proceeds of a company, ahead of common stock, but behind debt-holders.

- A fixed dividend amount, usually determined at the time of issuance and often higher than any dividend amount paid to common shares. Can be floating and tied to a common metric such as LIBOR.

- Certain voting rights, such as the approval of certain extraordinary events.

- Often contains protection against the issuance of other preferred stock (especially senior to a given issuance).

- Some preferred stock is convertible into common stock at a fixed ratio at the option of the shareholder. Such stocks are called convertible preferred stocks. They tend to be unique investments in that their share price is tied to the price of common shares. The actual terms for a given issue are spelled out at the time of issuance and should be fully understood by any purchaser. Because of the (usual) fixed dividend amount, preferred stock is often viewed as a hybrid security, with characteristics of both a bond and a stock share. The potential for capital gains from preferred stock is usually not as high as it is for common stock, but the (usually) higher and guaranteed dividend makes up for that. When selecting a preferred stock, the most important aspects are 1) call provisions, 2) bond rating, and 3) competitive yield.

Call provisions
Some preferred stock issues are callable. The issuer may call (buy) the issue at a specified price from the owner on or after a specified date. The details are listed in the prospectus for the issue. QuantumOnline does an excellent job of summarizing call provisions. It also provides links to the original prospectus for the issue. (But the bond ratings shown may not be current.)

Those considering purchase of a preferred stock should reseach call provisions. Yields are often supported by the call price. Paying a premium over the call price can result in having the issue called out from under you at a loss. Hence, preferred stocks near or after their call date often have their market value held down by the call price. That can cause them to show up in listings as having remarkably high yields. Be especially careful of issues paying above market yields. Many have call prices of $25 or $10. Preferred stocks priced just over those levels require extra attention.

Ratings on preferred stock
Bond ratings from AAA down to BBB are usually considered investment grade. Those rated lower are junk bonds. They are higher risk and hence lower rated bonds pay higher yield. Obviously a good buy is one that pays a higher yield than justified by its bond rating. QuantumOnline is reasonably up to date on bond ratings. But there is a recent scandal about bond rating agencies and mortgage backed securities. They are fairly reliable on preferred stocks, but it's a good idea to select issues with publically traded companies. Then you can read the annual report of the company, and read about its common stock to determine if its business prospects are good and especially is it reporting a profit or losses.

Yield is straightforward. Get the best yield you can consistent with reasonable risk, and plan to own at least five issues for diversification.

Limit orders
When buying preferred stocks, most are thinly traded. It is best to buy them with limit orders. Because bid/ask spreads tend to be large, market orders can result in trades at disadvantageous prices.

Trust preferred issues
A new development is third party trust preferred issues also called Asset Backed Securities. These are preferred stocks issued by an investment banker backed by a single long bond issued by a client company of the bank. They are listed and traded on major stock exchanges as preferred stocks. In essence you are buying a bond but at discount broker commissions and with published price history, a rarity with most bonds. These are often listed under the sponsoring bank or their brand name, but you can find them with a ticker lookup search for the company on QuantumOnline.

Suspension of dividends
One of the most recent features appearing in the prospectus of preferred stocks is a provision that allows the issuer to defer payment of interest for sometimes 20 quarters without penalty. Suspended payments are uncommon but the provision worries some investors. Read the prospectus before you buy to see if this feature is present. As one Fool community member noted, Ford Preferred S is one that did suspend its dividends during the auto crisis.

Qualified dividends
Be sure to research whether or not the dividends are qualified under IRS rules for the no or low income tax rates on qualified dividends. Most preferred stock payments are not qualified. They are like interest, fully taxed at ordinary income tax rates. Fool community member Crosenfield advises as follows: "The usual requirement is that if a company suspends dividends on the preferred, it cannot pay any dividends on the common until it brings the dividends on the preferred up to date. However, preferreds come 'cumulative' and 'non-cumulative.' In a cumulative preferred, if they miss a dividend they are under obligation to catch up before paying any dividends on the preferred. It is my observation, although perhaps not a requirement, that cumulative preferreds have a final maturity date, which may be far in the future (2050?) and the dividends are not qualified for tax purposes. The non-cumulative preferreds I've seen do not have a final maturity date and the dividends are qualified for tax purposes. I am not certain whether the company is obligated to catch up any missed dividends on the preferred before paying any dividends on the common, and I do not have an example where this happened."

Preferred stock can be a good way to supplement your income. With attributes different from common stock and other income investments, preferred stock is worth a closer look to find higher yields.

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The Motley Fool recommends Ford. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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