Fool.com: Why I Don't Use Preferred Stocks [Retiree Portfolios] July 31, 2000

Retiree Portfolio Why I Don't Use Preferred Stocks

Preferred stocks are a hybrid between bonds and stocks. They pay a somewhat predictable income like bonds, and may afford some potential for capital growth like common stocks. While they might play a part in a retiree's portfolio, they don't seem to be an appropriate substitute for bonds in a fixed-income ladder. They have no specific maturity date, are subject to market value fluctuation as interest rates change, and may be repurchased by the issuer at an inopportune time.

By David Braze (TMF Pixy)
July 31, 2000

Retirees face an investment dilemma. On the one hand, we need to generate income. On the other, we need growth to ensure that the inflation beast remains at bay. But, investing for growth means risk, an uncertain income, and possible losses. How, then, should we invest our assets to ensure income production as well as portfolio growth? In response to that question, over the last three columns I've talked about the importance of asset allocation, discussed the impact of bear markets, and highlighted the need for and construction of bond ladders. I thought those articles would end the topic as a major column theme.

At least that's what I thought. Unfortunately, I hadn't reckoned with the question of preferred stocks, the Lorelei of the equity world to retirees. A number of you have asked me to address the concept of including those securities in a retiree portfolio as a substitute for bonds. I admit that their use may sound tempting on the surface. After all, preferred stocks pay an income and, as stocks, they might rise in value as the company's fortunes and the overall stock market improve. Both of these features could give us the best of both the bond and stock worlds. For that reason, they certainly deserve our consideration to see how they may fit into our portfolios.

Not all companies issue preferred stock. In fact, most do not. A preferred stock is a hybrid security that shares the features of a bond and a common stock. Like a bond, the preferred stock will pay an income, but in the form of a dividend rather than interest. Usually, the dividend is fixed as a percentage of the share's par value at issue, but it may also be variable (within a narrow range) based on interest rates at the time the dividend is paid. Unlike a bond, the preferred stock has no specified maturity date. And, because preferred shares represent an equity holding in the issuing business, market price may increase along with any increase in the market price of the firm's common stock.

Unlike a common stock shareholder, a preferred shareholder typically does not have a vote in most company decisions. The preferred shareholder, though, does take precedence over the common shareholder for the payment of dividends. Common shares may not receive a dividend payment until those due preferred shares have been paid. Additionally, in the event of bankruptcy, preferred shareholders will receive payments after bondholders, but before common shareholders. The priority in the payment of dividends and in the division of a bankrupt company's assets are why "preferred" stocks have that designation.

Preferred stocks may be called participating, nonparticipating, convertible, cumulative, noncumulative, and callable. Participating shares may receive extra dividends along with common shares when the company has been profitable and the board of directors authorizes dividend payments to common shareholders. While the added payment won't be as large as the payment made to common shareholders, this feature nevertheless provides preferred shareholders added participation in company earnings. Nonparticipating shares do not receive a dividend payment beyond that specified as the normal dividend for those shares.

Convertible shares may be exchanged for a fixed number of common stock shares. This type of preferred stock affords the investor the opportunity to take preferred dividend payments forever, or to participate fully in common stock appreciation through conversion. Neither the conversion rate nor the conversion privilege will expire, and the conversion can be made at any time.

Cumulative shares provide the owner with a continuing claim to missed dividend payments. If, for whatever reason, the company's board of directors has skipped one or more dividend declarations, then all missed dividend payments will continue to accumulate, and those missed payments represent a valid claim for that shareholder against company profits. When dividend payments resume, all past and present dividends will be paid to preferred shareholders before common shareholders may receive a dividend. Noncumulative shares, as the name implies, is the other side of the cumulative coin. Missing dividend payments do not accumulate and are not made up on noncumulative shares.

Callable preferred stock may be repurchased (or "called in") by the issuing corporation for a fixed price. This feature allows the issuer some control over the preferred stock, because the redemption of those shares eliminates their dividend payments. Eliminating preferred dividends increases the earnings available to common shareholders. Most preferred stocks on the market contain a call feature.

While preferred stocks may have a place in a retiree's portfolio, in my opinion they do not qualify for a spot on a bond (or fixed income) ladder. 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, as I discussed last week, 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. The issuing company decides when to repurchase the shares, and that will usually occur when interest rates have declined. The company will endeavor to redeem a higher-paying preferred stock so it can issue newer, lower-paying shares. If my shares were called in, I would be forced to invest those proceeds at a lower interest rate, something that wouldn't occur had I invested in a similar or slightly lower-yielding bond maturing at a known and later date in the future.

I'm sure preferred stocks can play a part in a retiree's portfolio. I just don't see them in mine. I'll stick with securities that have a known maturity date for my fixed-income securities, and for growth I'll stay with common stocks.

See you next week. Until then, post away as usual on the Retired Fools board.

Best to all...Pixy