Hybrid Securities Behave Like Bonds, Trade Like Equities
When investors talk about holding shares in a company, they’re usually referring to owning common stocks. But there’s also a second, less widely understood type of stock that straddles both the equity and bond worlds: preferred stocks.
For equity investors motivated primarily by consistent, relatively high-income payments, preferred stocks may be worth a look — as long as you’re also mindful of their unique qualities and risks.
Regular Income Stream
In some respects, preferred stocks resemble their more widely known cousins, common stocks. Preferreds, for example, can be freely traded on stock exchanges, and they also offer the potential for capital appreciation (though typically less than that of common stocks).
In other ways, however, the two equity investment types behave differently, starting with their dividends. Common stock dividends are paid at the discretion of a company’s management team and tend to be more modest than preferred stock dividends. In contrast, preferred stock dividends will continue to be paid regardless, so long as the issuer doesn’t encounter serious financial trouble, decide to retire or call away the shares.
Another important difference is that preferred shareholders have a higher claim on a company’s assets. In other words, if an issuer suspends its income payments, preferred dividends will be repaid before those due to common shareholders (although interest payments due to bond owners receive the highest priority).
In fact, preferreds have much in common with bonds, especially in their response to changing interest rates. Both types of securities can be expected to see their prices fall when interest rates rise, as other income-generating vehicles paying prevailing rates start to look more attractive to investors.
Income Opportunities, But Be Cautious
Before you consider investing in preferred stocks, be mindful of their risks. For example, if a financially strapped company decides to suspend its dividend, the action would affect the price of its preferred stock. Thus, before investing, thoroughly evaluate the issuer’s ability to continue making its dividend payments.
Changing interest rate expectations pose another risk. If economic conditions improve, for example, and investors begin to anticipate higher future interest rates, preferred stocks typically experience price declines. (The reverse is true as well — if investors think rates are on their way down, preferred stock prices could rise.)
If you and your advisor are anticipating higher rates, you may choose to delay your investment in preferreds until market conditions appear more favorable. Beware also that many preferred stocks have a call feature, meaning that the company can redeem your shares on a certain date, and at a price that may be lower or higher than the current market price.
Also bear in mind that the preferred stock market tends to be dominated by only a few sectors — primarily financial institutions, as well as a smaller percentage of utilities and telecommunications companies — so you could unwittingly find yourself overexposed to certain areas of the economy. Accordingly, if you own preferreds, consider owning them as a relatively small component of a broadly diversified portfolio.
Ways to Invest
Investors have multiple flavors of preferred stock to choose from. Two common types include:
- Cumulative preferred shares, which entitle investors a right to accrued dividends if the income payments are temporarily suspended, or
- Convertible preferred shares, which provide investors with the option to convert their holdings into common stock at a given price.
Even though you can buy and sell individual preferred stocks, many investors gain exposure to this asset class through exchange-traded funds (ETFs) or mutual funds, which are professionally managed and generally offer greater diversification opportunities.
Preferred Stocks in Your Portfolio?
Preferred stocks present an investment opportunity as part of a diversified portfolio. Your financial advisor can help you determine whether preferred stocks belong in your portfolio and, if so, how best to invest.
Varying Tax Treatment of Dividends
In many cases, preferred stock dividends are taxed at the maximum dividend tax rate of up to 20% plus the 3.8% Medicare tax on net investment income. However, not all such dividends qualify for this favorable rate. Bank-issued “trust-preferred stock,” for example, pays dividends taxed at your ordinary income tax rate, which can be as high as 39.6% plus the aforementioned Medicare tax. As with most tax issues, the rules can be complicated, so be sure to get qualified advice about your own situation.