This article was updated on June 9, 2016.
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?
Preferred stock has two main attributes that common stock doesn't have. First, it can take precedence in receiving dividends over the dividends that common shareholders receive. Second, if a company liquidates, then preferred stock typically gets paid before common shareholders can recover anything.
You can visualize this by picturing the hierarchy of a company's capital structure. Common shareholders are at the bottom of the ladder, and they only get to make claims against company assets in liquidation once creditors and preferred shareholders have their claims satisfied. Bonds and other types of debt have higher priority than preferred stock, though, so even preferred shareholders can be left with nothing depending on how leveraged a company is when it fails.
For the most part, preferred shareholders don't get to vote in the general affairs of the company. Only in extraordinary events like a liquidation or bankruptcy situation do preferred shareholders get a vote.
Preferred stock and dividends
One particularly confusing aspect of preferred stock has to do with dividends. Preferred shareholders aren't automatically entitled to receive dividends. The preference only means that if a company pays dividends, then preferred shareholders get their payouts before common shareholders can get any dividends.
Some preferred shares have cumulative dividend features. That means that if a company chooses to suspend preferred dividends for a while, then preferred shareholders have the right to claim all their unpaid dividends before the company can start paying dividends to common shareholders. The amount of cumulative dividends can generally be calculated easily, because most preferred issues have specified dividend rates set forth in the stock issuance.
Special provisions of preferred stock
Different types of preferred stock have different provisions. With convertible preferred stock, a shareholder can convert preferred shares to a set number of common shares. Convertible preferred stock tends to trade as a stock-bond hybrid, which allows for capital gains if the common stock rises but provides downside protection if it falls.
In addition, most preferred stock has either a final redemption date or a call provision allowing the company to redeem it at an earlier time. When assessing preferred stock, it's important to look at call provisions, especially if the share price in the market exceeds the preferred stock's redemption value when called. Otherwise, you could suffer a loss between what you pay and what you get after the stock is called.
Finally, bear in mind that dividends on preferred stocks can be eligible for qualified-dividend tax treatment, in which case they're taxed at a lower rate. However, not all preferred stocks qualify, so be sure to check with the investor relations department of the stock you're considering to make sure it will get you the lower tax rates you want.
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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