What Are Preferred Stocks?
Preferred stocks are something of a hybrid between common stocks and bonds. However, they are definitely more income-oriented than growth-oriented, even though they have the name “stocks” in them. Before you take the plunge into preferred stocks, it’s important to understand not only how they compare with other types of investments, but also how different types of preferred stocks work. Whether or not preferred stocks are good investments depends on your own personal financial objectives and risk tolerance, so it’s a good idea to work with a financial advisor before you make any decisions. But to get you up to speed on just what preferred stocks are, here’s an in-depth look at the ins-and-outs of how they function and what purpose they serve in the investment world.
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Preferred Stocks vs. Common Stocks
Common stocks and preferred stocks are distinct asset classes, but they do share some overlap that can sometimes confuse investors.
Common stocks are generally considered growth investments. Although some can pay a dividend, investors generally own them in order to benefit from capital appreciation.
Preferred stocks, on the other hand, don’t generally appreciate in value. However, in exchange for their limited potential for capital appreciation, they typically pay much higher dividends than common stocks.
For example, while a common stock may pay a dividend of 3% or less — and oftentimes, 0% — preferred stocks tend to pay dividends in the 6% to 8% range, although this always depends on current market conditions.
The reason that preferred stocks generally see limited capital appreciation is that they don’t represent ownership in the profits of the underlying company. Rather, they are simply agreements that a company will pay dividends to shareholders and potentially redeem the shares at par value at some date in the future.
Preferred Stocks vs. Bonds
Thanks to their income-generating nature, preferred stocks are more akin to bonds than common stocks. Like bonds, preferred stocks typically pay a fixed rate of interest and often have maturity dates. One important distinction, however, is that while bonds always have a set maturity date, usually between one and 30 years, preferred stocks may be “perpetual,” meaning there is no requirement that they are ever redeemed. When preferred stocks do have a maturity date, it typically extends 40 or 50 years, and perhaps even longer. In that sense, preferred stocks carry a bit more risk than most bonds. However, they are both susceptible to interest rate risk, or the risk that their value will decline when market interest rates rise.
Types of Preferred Stocks
Although all preferred stocks have the same general structure, there are distinguishing features marking the different types of preferred stocks. In all, there are generally considered to be six types of preferred stocks, as follows:
Callable preferred stocks
Cumulative preferred stocks
Noncumulative preferred stocks
Participating preferred stocks
Convertible preferred stocks
Perpetual preferred stocks
Callable preferred stocks give the issuer the option to redeem existing shares at a specified price at a future date. The issuer generally isn’t obligated to redeem or “call” these shares, but if it does, it generally has to pay shareholders a premium over the original par value.
Cumulative preferred stocks have a provision that if any dividends are missed, they must be added to future payouts to make shareholders whole. Dividends that are missed are considered in arrears and must eventually be paid to owners of the preferred stock.
Noncumulative preferred stocks do not have the requirement to pay dividends that are in arrears. If a dividend is missed, it is simply skipped, and shareholders have no claim on it in the future.
Participating preferred stocks enjoy some of the benefits of common stocks, in that shareholders are rewarded with bonus dividends if companies reach certain profit levels.
Convertible preferred stocks offer shareholders the ability to exchange their shares into common shares of the underlying company. Conversion privileges always have specified terms that are spelled out in the prospectus.
Perpetual preferred stocks are issued with no maturity date. This can expose shareholders to both interest rate risk and market risk. Since the shares will never be called in, their desirability is more tied to the economic performance of the underlying company.
Benefits of Preferred Stocks
The primary benefit of a preferred stock investment is income. Preferred stocks often pay dividends that are higher than both common stocks and bonds. This can make preferred stocks particularly interesting to retirees or those on a limited or fixed income.
Another benefit of preferred stocks is their higher rank in the capital structure of a company. In the event of corporate default, bondholders are paid off first, but preferred shareholders are next in line, ahead of common shareholders. Although you’re not likely planning for the default of the company you invest in, it’s important to note the pecking order in the event of any liquidation distributions.
Different types of preferred stocks also have additional perks depending on their structure. For example, callable preferred stocks may generate a premium for the stockholder if the company decides to call in the shares, and convertible preferred stocks offer the flexibility of access to common shares.
Risks of Preferred Stocks
The primary risk of owning a preferred stock is interest rate risk. If you buy a preferred stock paying a 7% dividend, for example, and market interest rates move up to 10%, the share price of your preferred stock will decline — and perhaps significantly. Whereas with shorter-term bonds investors can simply hold on and wait for the issuer to pay back principal at maturity, preferred stocks are such long-duration investments that you may wait the rest of your lifetime without getting your principal back. In the case of perpetual preferred stocks, there’s no promise of the return of principal at all, meaning that if you bought the preferred stock in a low-rate environment, it’s likely that the share price will never recover to the price you paid.
Default risk is another concern for preferred stocks. Although the issuer promises to pay you regular dividends for the life of the preferred, if it encounters financial difficulty and goes bankrupt, you may end up with nothing. Although preferred stocks rank higher in the capital structure than common stocks, they fall below bonds, meaning there is often not any money left to pay off preferred stocks in the event of a corporate default.
Are Preferred Stocks for You?
Preferred stocks are primarily a good investment for those in need of income. The high dividend yields that most preferreds offer, along with the relative stability of their share prices compared with common stocks, make them generally suitable for more conservative investors, such as retirees. However, this is not to suggest that preferred stocks are without risk.
Rising interest rates can hurt the share prices of preferred stocks, just as they would with bonds. If the issuing company exhibits financial instability, the price of preferred stocks may take a hit as investors fear that dividends may be suspended or even eliminated. Typically, common stocks will drop more than preferred shares, but there’s still a risk of the financial insolvency of the underlying company.
Preferred stocks are also not the best option if your investment objective is capital appreciation. Even in the best of times, preferred stocks don’t generally trade up in value based on the economic performance of the issuing company. Only falling interest rates are generally responsible for driving up the share prices of preferred stocks.
Few investors have a portfolio composed entirely of preferred stocks. Often, preferred stocks occupy just a portion of a portfolio, alongside bonds, Treasury securities, CDs, savings accounts and other income-oriented investments. Some investors also own growth stocks in addition to their income investments, depending on their objectives. Which blend is the most appropriate for your portfolio will depend on your personal financial needs, which should be discussed with a financial advisor.
Information is accurate as of Sept. 23, 2022.
This article originally appeared on GOBankingRates.com: What Are Preferred Stocks?
