Ted Allrich is the founder of The Online Investor and author of the just released book: Comfort Zone Investing: Build Wealth And Sleep Well At Night. In this weekly column, he'll offer advice to investors who are just getting started.
Preferred stocks are much like squirrels. They don't live on the ground. They don't fly in the air. They're always somewhere in between. A preferred is like that. It's not equity in a company. It's not debt of a company. It's always somewhere in between.
That state of being, being in between, sometimes pays handsomely to investors. Other times, it leaves them totally isolated, with nothing to show for their investments. Here's how preferred stocks work, and why they're really for institutions, not individuals. Still, individuals may find them irresistible when they see some of the yields these hybrids offer.
Preferred stock usually carries a rate of payment, stated as if it were a bond. For example, General Motors (NYSE: GM) has a 6.25% preferred stock, as well as others. Most preferred stock is issued at $25 a share and pays semi-annually. That payment is not guaranteed. But most of the time it is cumulative, meaning that if a payment is missed, it will be made up when the company has the funds. One source of reassurance for investors when it comes to a dividend payment: the preferred stock has priority over the common shares for dividends. So common dividends will be gone before preferred stocks' dividends are.
And those payments are dividends, not income, as from a bond. That distinction is important because institutions exempt 85% of the dividend for tax purposes. That same tax treatment is not allowed for individuals. Furthermore most preferred stock is negotiated between the company and institutional investors, setting a payment rate that is acceptable for both sides at the time of pricing.
When companies have more than one preferred stock outstanding, each issue is designated by a Series. The first series is usually Series A, then Series B, etc. Sometimes a new series will have priority over the older ones. Most of the time, they trade on equal terms, meaning that each series will receive its dividend or none will. However, this is an important consideration when it comes to preferred stock: investors need to know if there are preferred shares with a higher ranking than the issue they're considering. That higher ranking will not only affect the payment schedule but also the preference in case of liquidation.
Liquidation occurs when a company goes out of business. As assets are sold, the first funds go to pay off creditors. They have the highest priority in the money chain. Once creditors are paid, the preferred shareholders receive the remaining distributions. If there is anything left after preferred shareholders receive their payments, then the equity holders get the rest.
Preferred shares come in two forms: straight and convertible. The straight issues receive payments and have no participation in the equity growth of the company. Convertible preferreds have a conversion factor that allows the preferred to be converted into common stock. While convertible owners wait for the conversion price to occur, they are paid a dividend, usually smaller than a straight preferred dividend.
There are several caveats about preferred stock. The first and foremost is that it's very, very difficult to find out much about them. They don't trade very much, except the larger issues which are listed on an exchange. But getting good details on any preferred issue almost requires an investor to call the company and get specific information on it. Information such as the Call Price and when it is in effect.
The Call Price is the price at which the company can take the preferred back from investors. Companies do this when interest rates are lower, and the outstanding issue can be refinanced with a lower cost of borrowing. As a preferred holder, this is exactly what investors don't want. Usually, the call price is at a premium to the issue price after the call price protection period is over. Call price protection is simply the length of time allowed before the company can call the preferred from holders. But the premium decreases each year beyond the protection period. Eventually the company has the right to call the preferred at the issue price.
If you've followed the thread of this piece, you realize that preferred shareholders don't have a lot of advantages (at least straight preferred holders). They simply receive a dividend, one that isn't guaranteed but does have priority over common dividends. They don't participate in any upside in the stock appreciation. To top it off, they don't have protection against having their investment taken away (other than the initial period of protection) if rates become more attractive to the company.
That's why individual investors need to tread carefully into the preferred markets. They are really meant for institutions. They are extremely difficult to research. They have no voting rights attached. They have several unpleasant features that work against the investor. But they oftentimes have returns that are just too attractive to resist. That GM issue mentioned above currently yields over 12%.
PreferredsOnline – “Every properly constructed portfolio will contain securities to generate income.”
