What Is Preferred Stock?

It's not the sexiest thing going, but preferred stock, which typically yields between 6% and 9%, can play a beneficial role in income investors' portfolios.

As long as those investors know exactly what they're getting into.

Before we get started, know that preferred stock as an asset class is somewhat complicated and covers a lot of ground, so we'll be hitting only some of its more salient characteristics here.

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Suffice to say, that – as with any investment – it's critical for individual investors to understand the particular terms and features of the preferred stocks they are buying.

How does preferred stock work?

Preferred stocks are often called "hybrid" securities because they possess both bond- and equity-like aspects. Like common stocks, preferreds represent an equity interest in a company. However, like bonds, they also pay regular interest or dividends based on the face – or par – value of the security on a monthly, quarterly or semi-annual basis.

On the upside, preferred stocks usually feature higher yields than common dividend stocks or bonds issued by the same firm. Their dividend payments also take priority over those attached to the company's common stock dividends. If the company faces a cash crunch, common stock dividends get cut first.

And what happens if the company misses a preferred dividend payment? Well, it depends.

If the preferred stock is a cumulative issue, the unpaid dividends are considered to be in arrears and accumulate in an account. (Missing a payment on preferred stock is not considered to be a default event.) Those dividends must then be distributed to preferred shareholders before any dividends can be paid to common stockholders.

However, if the preferred stock is non-cumulative, the preferred stockholder is left holding the bag.

That's an important distinction. Although preferred shareholders have seniority over common shareholders when it comes to dividend payments, those dividends are not necessarily guaranteed.

What are the downsides to owning preferred stock?

Preferred stockholders also stand in line ahead of common stockholders in case of bankruptcy or liquidation. That said, a long list of creditors and bondholders have seniority over preferred shareholders should financial catastrophe strike.

If common stockholders are at the bottom of the bankruptcy food chain for recouping at least some of their capital, preferred stockholders are closer to the middle – but not by all that much.

Among the downsides of preferred shares, unlike common stockholders, preferred stockholders typically have no voting rights. And although preferred stocks offer greater price stability – a bond-like feature – they don't have a claim on residual profits. That means preferreds don't share in the potential for price appreciation that common stocks do.

As such, preferred stock prices move in a narrower range, and tend to do so more on interest-rate risk or the issuing company's credit risk.

Some would argue those are high prices to pay to secure only a somewhat higher yield. But the caveats don't end there.

How preferred stocks are like bonds

Preferred stocks come with maturities, which tend to be very long. True, some preferred stocks are perpetual, meaning they never mature, but maturities of 30 years or longer are typical.

Which brings us to this thought experiment: If you were buying a bond instead of a preferred stock, ask yourself if you would be comfortable owning an instrument with such an extended date to maturity for the yield you're receiving and the risk you're assuming.

It's also important to remember that securities with longer maturities are more sensitive to changes in interest rates. Just as with bonds, preferred stock prices fall when interest rates rise.

At the same time, preferreds are often callable. That is, the issuer reserves the right to redeem the security after a certain period of time has passed. As with bonds, preferred shareholders run the risk that the issuer will exercise its call option when interest rates are low.

No income investor wants to be handed back a big ol' bag of money to invest when interest rates are lower rather than higher.

Should I buy preferred stock?

Going back to the plus column, preferred stocks are transparent and convenient in a way that individual bonds are not. They trade on a stock exchange, which gives them price transparency and, importantly, liquidity.

Be forewarned, however, that depending on the size of the issue, the bid-ask spread on a preferred stock can be comparatively wide. That means it might be harder to buy or sell your preferred stocks at the prices you seek.

To sum it up:

• Preferred stocks are usually less risky than common dividend stocks, and carry higher yields, but lack the opportunity for price appreciation as the issuing company grows. They also go without voting rights.
• Preferred stocks are riskier than bonds – and ordinarily carry lower credit ratings – but usually offer higher yields. Like bonds, they are subject to interest-rate and credit risk.

The big selling point is that preferred stocks can offer steady income with higher yields. And, yes, they could very well deserve a place in your portfolio, complementing, say, your allocations to dividend stocks and fixed income investments.

But, as with every investment opportunity, you must do your own careful due diligence first.

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