Investing in Preferred Stocks

If you know anything about preferred stocks, you probably know that they tend to pay sizable dividends. But odds are, you don't know much more about them than that. I myself was in the fairly-ignorant-about-preferred-stock camp until recently. Here's much of what I've learned about them, boiled down into a nutshell.

The basics
"Common stock" is what most of us buy when we invest in the likes of ExxonMobil (NYSE: XOM  ) , VerizonCommunications (NYSE: VZ  ) , Intel (Nasdaq: INTC  ) , and Pfizer (NYSE: PFE  ) . But companies can offer more than just common stock -- some offer preferred stock, as well. Like common stock, shares of preferred stock represent partial ownership of a company. So if you own some shares of AT&T (NYSE: T  ) , you are literally a co-owner of the company -- though you might not own much more than the equivalent of a doorknob at headquarters.

While preferred shares are technically shares of stock, they behave much like bonds, carrying a fixed dividend. By fixed, I mean that it usually stays the same for the life of the stock. (Dividends paid on common stock are often increased over time.) Preferred dividends are also usually "cumulative," meaning that if a company runs into some trouble and can't pay its dividends, if and when it recovers, preferred stockholders can expect to receive the dividends owed them -- and these are paid out before common stockholders get anything.

Preferred stock comes in many forms. There are traditional preferred shares, whose dividends are taxed at the new 15% rate, and newer "hybrid" versions, often called "trust preferreds," which are taxed at higher rates. Some preferred shares are convertible into cash or common stock -- at the discretion of the investor or the company -- or according to some formula. (Note that this means an investor may be forced to exchange his preferred stock for cash or stock, whether he wants to or not.)

It's often other corporations that buy preferred stock in large quantities -- because of tax breaks they enjoy on such investments.

The benefits
Preferred stock usually pays a fixed dividend that's higher than the common stock dividend. This is attractive to those who seek dividend income. In fact, Mathew Emmert, author of our Motley Fool Income Investor newsletter, talked about them at length (as well as several high-dividend paying common stocks) in his "7 Paying 7" special report -- free when you subscribe to Income Investor. While the Standard & Poor's 500 currently sports an overall dividend yield of around 2% and high-quality corporate bonds offer around 6%, preferred shares are averaging 7%, with some paying yields above 10%.

Another benefit will appeal to those who like to be near the front of a line. If a company runs into trouble and seeks bankruptcy protection, holders of preferred shares take precedence over holders of common stock. So while common stockholders often receive nothing if a company seeks bankruptcy protection, preferred shareholders may end up with a few cents on the dollar. Of course, preferred stockholders still aren't at the front of the line -- that's where you'll find creditors, such as bondholders and even employees.

Finally, preferred stock tends to be considerably less volatile than common stock.

The drawbacks
If all this information has you intrigued, read on. As you might have suspected, there is a downside to these beasts.

For starters, while bond-like, preferred stock is riskier than bonds. As with bonds, when interest rates rise, preferred stock can become less valuable. Also like bonds, preferred stock is rated by agencies such as Standard & Poor's and Moody's (NYSE: MCO  ) .

Preferred shareholders generally have no voting privileges. This isn't that big a drawback for most investors, but if you like to have your say, you won't with preferred stock.

Perhaps the most critical drawback is the fact that preferred shares tend to not appreciate in value as quickly as their common stock counterparts. Remember the "low-volatility" benefit? Here's that silver lining's cloud: while a company's common stock may soar, its preferred shares may just sit there, or may budge just a little.

Good for retirees?
Retirees are one group of investors who often are especially drawn to preferred stocks. That makes sense -- retirees typically need investments that kick out some income, and that's what preferred stocks do. But hold on. Dave Braze, known to many in Fooldom as TMF Pixy, is our retirement expert, having been a professional financial planner and also a retiree. He's written an article on "Why I Don't Use Preferred Stocks." What's his beef with preferred stock? Here are his main points, in his own words:

  • First, they have no maturity date, so there is no "guarantee" on the principal such as that with a bond held to maturity.
  • They will also fluctuate in market value with every shift in interest rates, so in that sense they will mimic a bond fund because the ultimate share redemption value is unknown.
  • Additionally, while preferred stocks may appreciate in value, that appreciation typically occurs in a very narrow range, far below that of common stock. Thus, the potential for price growth seems too small for me, particularly in view of the interest rate risk previously cited. I'll get far better (and probably more reliable) growth investing directly in common stock.
  • Finally, the call feature in most preferred shares could seriously disrupt the stability of my fixed-income portfolio allocation, and it's an event that is totally beyond my control.

This isn't to say that every retiree -- or investor, for that matter -- should steer clear by any means. Just don't look at preferreds as a silver bullet and understand what you're investing in.

Where to find them
My former colleague, Todd Lebor, explains:

Finding preferreds is easy -- just look on the balance sheet between debt and common stock. Once you've spotted preferred stock, pull up a comfy chair, crack a cold one, and read the preferred stock prospectus (it's probably a 423B prospectus filing). Are the dividends cumulative? Are the shares redeemable and, if so, when? What is the likelihood of redemption? Has the board of directors ever suspended dividends? (If so, it's a bad sign -- management usually only cuts dividends as a last resort. Suspending dividends is a sign of cash flow trouble.)

"Preferreds can be bought and sold just like common stocks. Companies that issue them often have more than one series, using letters of the alphabet to distinguish them (e.g. Series A, Series B, etc.).

The bottom line
So what's the upshot for us individual investors? The right preferred stock investment might serve you well. Some are tied to strong, reliable companies. And some do offer attractive dividend yields. If you're interested, learn more before investing any moolah, because preferred stock has a few more quirks. To learn more about preferred stock, read "The Power of Preferred Stocks" by Todd Lebor and also this article in Kiplinger's magazine.

Another good resource for investors seeking high dividends is the aforementioned Motley Fool Income Investor newsletter, which focuses on stocks offering hefty dividend yields and recommends at least two investments each month. (Right now is the last week to sign up as a charter member and get $30 off the regular price, if you're interested. Money back guaranteed, of course, if you find it doesn't float your boat.)

Selena Maranjianalmost gave herself a black eye the other day, bonking herself with her car door. She owns some common stock in Pfizer.For more about Selena, view her bio and her profile. You might also be interested in these books she has written or co-written:The Motley Fool Money GuideandThe Motley Fool Investment Guide for Teens. The Motley Fool is Fools writing for Fools.


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