Preferred stock is a little-known type of investment that combines the qualities of both bonds and common stocks.
Preferred shares don’t generate nearly the kind of excitement that common shares do. You won’t find TV networks streaming a ticker of preferred prices during market hours, and I can say unequivocally that no financial advisory client of mine has ever been giddy or anxious about preferred holdings.
But that doesn’t mean they aren’t, in many cases, a wise investment. When counseling clients, I’ve often told them that investing should be boring, not exciting. In that regard, preferreds fit the bill.
So what are preferred shares, exactly, and how do they differ from common shares? Here are some factors to consider as you decide whether preferred shares are right for your portfolio:
— What is preferred stock?
— Pros and cons of preferred stock.
— When preferred shares are the better choice.
— Preferred stock risks vs. rewards.
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What Is Preferred Stock?
As the name implies, preferred stock is a form of equity, but it gives investors a higher claim on a company’s assets and earnings compared with common stock. That means in case of bankruptcy or liquidation, preferred shareholders are behind bondholders in terms of who gets paid first. But they’re ahead of common shareholders, who are taking the most risk.
Preferred shareholders are also entitled to a fixed dividend payment that must be paid before any dividends are paid to common shareholders.
But in exchange for that preferential treatment, preferred shareholders typically do not have voting rights, or they may have limited voting rights compared with common shareholders.
Pros and Cons of Preferred Stock
Unlike common shares, preferred shares have a fixed par value and may be issued with a maturity date or a call date, after which the company can redeem them. They sound a lot like bonds, don’t they?
Preferred shares are generally considered to be less volatile than common shares and may be more suitable for investors seeking steady income and capital preservation. They’re not ideal vehicles for investors seeking growth, for many of the same reasons bonds aren’t appropriate growth investments, with the occasional exception of high-yield bonds.
“They can offer a superior yield to bonds or stock dividends from the same company. We view them as having a seat at the table but only buy them when the value and strength of the issuing company make sense.” — Andrew Aran, managing partner at Regency Wealth Management
Preferred shares have a role in generating income, though, which is the name of the game in retirement.
Andrew Aran, managing partner at Regency Wealth Management in Ramsey, New Jersey, says his firm maintains a modest allocation to preferred shares when it sees an advantage.
“They can offer a superior yield to bonds or stock dividends from the same company,” he says. “We view them as having a seat at the table but only buy them when the value and strength of the issuing company make sense.”
When Preferred Shares Are the Better Choice
Aran describes one client situation where preferreds were clearly the superior choice: In 2009, a client held some noncallable convertible preferred shares that had been issued at rates over 7%. The underlying common stock price had fallen to such a low level that the preferred shares were unlikely to convert to common shares. When that happens, the convertible is termed “busted,” as it now functions essentially as a bond.
“These are still outstanding and currently yield over 6%,” Aran says.
Marcus Holzberg, lead wealth advisor at HWM Financial Advisors in Corte Madera, California, also has clients who hold preferred shares and have had good experiences with them. “It can be very beneficial for people who need current income, plus, depending on the preferred stock, they may also have some tax advantages,” he says.
He adds that occasionally preferred shares can be purchased at a discount to their par value and provide excellent total return.
READ: Funds to Add to Your HSA.
Preferred Stock Risks vs. Rewards
“One caveat to preferreds is that they typically have long maturities, so they can be quite volatile when interest rates change,” Holzberg says.
On the flip side, he points out that preferreds can deliver a steady return relative to common shares. “They are more of a substitute for bonds because they are fixed-income securities. On a common stock, the dividend can go up or down. With preferred stocks, unless they are floating-rate, you are getting a fixed dividend yield,” Holzberg says.
Nilay Gandhi, senior wealth advisor at Vanguard, also points out the higher risk associated with preferreds. But he agrees that these shares can be a useful tool for advanced investors seeking income-producing equities, as they provide larger dividend payments than common stocks.
“For most investors, traditional stocks and bonds provide plenty of diversification for their portfolio,” he says. “Sophisticated investors may want to consider strategies that use hybrid investments, like preferred stocks, but they should be aware of the additional complexity.”
That last point is similar to something I’ve underscored with my own clients. It’s certainly possible, and actually quite easy, to add unnecessary complexity to an allocation. In many cases, a plain-vanilla portfolio of common shares and bonds, allocated to reflect an investor’s goals, time horizon and risk tolerance, will be sufficient to achieve his or her objectives.
“Sophisticated investors may want to consider strategies that use hybrid investments, like preferred stocks, but they should be aware of the additional complexity.” — Nilay Gandhi, senior wealth advisor at Vanguard
For those investors who already owned preferreds before they became my clients, deciding to sell or hold was a matter of ascertaining whether those securities fit into their plan at that time.
“We’ve had clients arrive with them, and we have also recommended them to individuals to help them meet their current income needs,” says Holzberg. “For clients who join our practice with them, so long as they are investment grade and high-quality, we usually advise that clients keep them.”
In other words, as with all aspects of portfolio construction, each situation is unique. That’s as true with preferred shares as with all other asset classes.
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Preferred Stock vs. Common Stock: What’s the Difference? originally appeared on usnews.com