With the S&P 500 and NYSE Composite indexes trading near the levels they did two years ago, many investors have turned to income-generating securities.
Dividend-paying stocks, as well as bonds, are the most obvious choices, but there are other vehicles, including preferred stocks.
Preferred stock is frequently misunderstood and overlooked. As the name suggests, preferreds are equities, but they also have characteristics of bonds. Currently, they offer higher yields than many dividend-paying stocks.
[Sign up for stock news with our Invested newsletter.]
Here’s a look at preferred stock and when it may be a good fit for your portfolio:
— What is preferred stock?
— Common stock vs. preferred stock.
— Should investors buy preferred stock?
— Why do companies issue preferred stock?
— What are convertible preferred shares?
What Is Preferred Stock?
Preferred stock is a type of ownership stake in a company that combines the characteristics of common stock and bonds. Preferred shareholders have a higher claim on a company’s assets and earnings compared with common shareholders, but they rank below bondholders in terms of seniority. In the case of bankruptcy, for example, bondholders would be the first in line to claim any assets, then preferred shareholders and finally common shareholders.
Common Stock vs. Preferred Stock
One key feature of preferred shares is that they typically offer fixed dividends, which are paid to shareholders before any payouts are distributed to common shareholders. These fixed dividends provide a stable income stream, making preferred shares attractive to income-seeking investors.
But there’s a catch: Unlike common stockholders, preferred shareholders usually don’t have voting rights in corporate matters.
In addition, some preferred shareholders receive cumulative dividends. This ensures that any unpaid dividends accumulate and must be paid to preferred shareholders before common shareholders receive dividends.
According to Andrew Aran, managing partner at Regency Wealth Partners in Ramsey, New Jersey, “Preferred stocks are often callable so that the issuer can retire them at par after a certain date.”
He points out that shares with lower par values, such as $25, are typically owned by retail investors, while those with higher par values, such as $1,000, are held by institutions. Par values are the original value of the share that remains fixed for the life of the security and are the value upon which the dividend is calculated.
Should Investors Buy Preferred Stock?
Investors seeking yield may want to consider preferred stock. According to Mitch Bodenmiller, portfolio manager and research analyst at Ohio-based Buckingham Advisors, the dividend yield on preferred shares is often higher than the yield on common shares.
The largest preferred exchange-traded fund, the iShares Preferred and Income Securities ETF (ticker: PFF), has a yield of 6.8%, versus the SPDR S&P 500 ETF Trust’s (SPY) yield of 1.5%.
Bodenmiller also says short-term investors may be more interested in preferred stock. “The share price of preferred stock typically fluctuates much less than common stock,” he says.
For that reason, preferred shares can provide a level of stability and capital preservation.
Robert Johnson, professor of finance at Creighton University, says preferreds are often attractive to investors who normally avoid stocks, opting for bonds.
He has a word of caution for investors in preferred shares, which don’t typically appreciate in price to the extent that common shares do. “Don’t get seduced by the name,” Johnson says. “Preferred stock really isn’t better for investors if the company is wildly successful. Preferred shareholders don’t share in the upside like common shareholders do.”
[READ: 9 of the Best Mutual Funds to Buy Now]
Why Do Companies Issue Preferred Stock?
There are several reasons why companies issue preferred stock. For starters, preferred shares offer a way to raise capital without diluting ownership or sacrificing voting control.
Issuing preferred shares allows companies to diversify their capital structure, access additional funding sources and cater to investors with specific preferences for steady income and reduced risk. That tends to be a different group of investors than those who gravitate toward common shares.
Preferred stock can also be a way of avoiding new debt. “If companies raise cash through debt, it raises their debt-to-equity ratio and adds risk,” Bodenmiller says. “The use of too much debt can create financial stress.” However, he says, raising cash through a common equity offering, which can dilute existing shareholders, can harm the company’s stock price.
“Issuing preferreds can potentially protect against using too much leverage while also avoiding diluting the shares, and voting power, of common stockholders,” Bodenmiller says.
Aran points out that in addition to other advantages, preferred shares can help shore up the issuer’s capital base.
Preferred stock can also receive ratings from agencies such as Standard & Poor’s, Moody’s and Fitch that assess creditworthiness and the financial stability of the issuing company. These ratings help investors evaluate the credit risk associated with the preferred shares.
The need for capital can be a key driver when companies issue preferred stock.
Aran recalls that in 2011, when investors fretted about Bank of America Corp.’s (BAC) need for capital, Warren Buffett purchased $5 billion of the bank’s preferred stock. The dividend totaled $300 million a year.
That deal came with warrants to acquire common shares. In 2017, Buffett exercised those warrants to acquire 700 million common shares at a value of $7.14 each, significantly less than where BAC shares were trading at the time. Buffett made about $12 billion with that move and became the bank’s largest shareholder.
What Are Convertible Preferred Shares?
Preferred shareholders may have certain additional rights, such as the ability to convert their preferred stock into common stock or participate in any potential upside if the company is sold or goes public.
Convertible preferreds, says Aran, “can be converted into common shares after a certain date if the stock is at or above a target price. Some have mandatory conversions after a set date.”
David Scranton, founder and CEO at Sound Income Strategies in Fort Lauderdale, Florida, points out that shareholders may get a lower yield on convertible preferreds in exchange for that right.
“You’re giving up a little bit of yield, or income, but you have the option of converting it to common stock if shares perform well,” he says.
More from U.S. News
8 Things to Look For in a Quarterly Report
What Is Preferred Stock? originally appeared on usnews.com
Update 07/28/23: This story was previously published at an earlier date and has been updated with new information.
