The landscape of investing is vast and there's no way to know everything about everything. Sometimes it's best to leave some investment products to other people and stick with something that's easy to understand, but preferred stock isn't one of those. Once you understand it and how it fits in to your portfolio, you'll wonder what you were missing.
What is it?
If any class of investments should feel rejected or ignored, it's preferred stock. The bond world doesn't claim it because it trades on stock exchanges and has the name stock. The stock world doesn't claim it because its actually closer to a type of bond than it is a stock. It's price changes more based on interest rates than it does market conditions. In short, nobody wants to claim the preferred stocks of the world but they're valuable none the less.
Some of the reasons companies issue preferred stock are complicated but the two textbook reasons may be alternative financing and takeover defense. First, most preferred stock pays a dividend which means that a company doesn't have to pay it every month (although it's rare that quality preferred stock wouldn't be paid). They can choose not to pay for as long as they please and make up the payments later on. When they issue bonds, they have to make the payments on time or risk affecting their credit rating.
Although not common with most companies, preferred stock can also be used to fight against hostile takeovers by issuing preferred shares with a poison pill attached to make the company less attractive as a takeover target.
Finally, if the company filed for bankruptcy, the assets are divided up in the hopes that shareholders won't walk away with nothing. Some creditors and debt holders get first dibs on the assets but after that, bond holders get paid, then preferred stock holders, and finally, if there's anything left, common stock holders. Holding preferred shares moves you one step up the ladder although realistically, even preferred stock holders won't get much.
Types of Preferred Stock
This is where preferred stock starts to look a lot like a bond. There are different types of preferred stock and in order to understand the many different types, you'll have to do a lot more reading but the easiest to understand is convertible preferreds. Convertible shares allow you to exchange your preferred stock for a certain amount of common stock where non-convertible doesn't have that option.
For the average investor, it's important to understand how your preferred stock works, but there's a better than average chance that you won't use the convertibility feature for long time if at all.
How to Use Preferred Stock
There are some problems with buying bonds. First, they aren't as liquid as stocks. They're more of a hassle and more expensive to buy and sell. Bonds have a minimum purchase which isn't possible for many individual investors and still keep a diversified portfolio.
But if you're an income investor looking for a safe, steady, and secure way to create an income stream, preferred stock is a great way. The bulk of the preferred stock is issued by financial companies but you can find preferred shares in other sectors as well.
What kind of dividends come with preferred shares? Much like common stock, the rates are higher when you purchase shares in a riskier company. Some of the world's largest banks have payouts of 8% or more while other, more risky companies pay well in to the double digits.
The Downside
The major downside of preferred stock for the individual investor is that in most cases, it takes a long time to see any capital appreciation. When you buy preferred stock, you're buying it for the dividend so make sure that the dividend is high enough that it captures a reasonable rate of return once you subtract inflation. Inflation may not be a problem now but as the European economy recovers, inflation can take a large piece of the dividend.
Related to this, the market is full of common stock that pays equally high dividends but in a market where some European common stock is at historic lows, you may be able to combine a high dividend yield with better than average growth prospects.
In Conclusion
Treat preferred stock like you would any other stock by setting a stop price just in case something happens but aside from that, keep it in your portfolio and create a low maintenance income stream that keeps you away from the hassle of owning bonds especially if you don't have experience in the bond world.
Andy is the co-founder of one of the leading credit card comparison websites in Australia. Click here to go to CreditCardCompare.com.au to read his reviews of the top credit cards on the market, or visit their personal finance education center for his articles on managing money.
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