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In today’s near-zero rate environment, fixed-income investors are hungry for returns to keep their cash flows on track.
Preferred income securities can help increase overall average returns, but research and due diligence are necessary to minimize risks. Preferred stocks are often misunderstood by investors. So, I’ll attempt to offer a clear, brief explanation before digging into their pros and cons.
Much like traditional bonds, preferred stocks are issued at a fixed par value (usually $25) and pay scheduled, fixed dividends to investors. Preferred stocks act like bonds in that they offer a fixed or floating rate of income, but investors are rewarded for their stock rather than bond risks. Many are rated by independent credit rating agencies, and typically, they are rated lower than bonds because they offer fewer guarantees and claims on assets.
Bond investors hold a debt obligation on a company, which means they have a right to collect interest during its term and a return equal to the original principal investment once the bond reaches maturity. The bond represents an investor’s claim on the assets of a company in the case of a default or bankruptcy. Unlike bonds where a company risks defaulting if payments are missed, preferred dividend payments can be withheld by the issuing company without facing default risk. Traditional corporate bonds often produce higher yields thank preferred stocks, however.
Companies issue two types of stock: common and preferred. Common stock entitles owners to vote at shareholder meetings, receive dividends and participate in a company’s potential gains in the form of capital appreciation – or potential losses. Preferred stockholders usually lack voting rights, but they receive dividends before common shareholders and receive priority if the company goes bankrupt and its assets are liquidated. Preferred stockholders have claim to the income of a company over common shareholders, but they do not have claim to company assets like bondholders.
Preferred stocks can be a valuable component of your investment portfolio – particularly as a means of driving long-term fixed income. They can be used to:
Additionally, some preferred securities are taxed as qualified dividends, which offers investors a tax break over funds taxed as ordinary income.
Preferred stocks have an upside for the issuing companies as well. They provide a relatively cheap way to raise capital, can be used in balance sheet management to keep bond issuance low and offer flexibility in suspending dividend payments when needed. Depending on whether the issued preferred stock is a cumulative or non-cumulative interest payment, a company might have to pay investors missed dividends before restarting future ones.
Because preferred stocks are viewed as equity rather than debt, they help companies reach regulatory and rating agency levels of capitalization on their books, which makes them an attractive option for issuers like banks, real estate investment trusts, and insurance, utilities and communications companies. As stocks, they count toward a company’s equity retirement.
The type of preferred shares you select will impact the outcome, so it’s important to understand the five main types: Convertible, Callable, Cumulative, Participatory and Perpetual.
Although preferred stocks can have benefits for investors and the issuing companies, they also have risks that cross both equity and fixed-income worlds. When considering adding high-yield stocks or bonds to their portfolios, investors should be familiar with the following potential risks:
Today, preferred securities have a wide range of structures that can impact individual valuations and suitability. So, if the pros have piqued your interest, but you’re not sure the type or structure that best fits your needs, talk it over with a financial advisor before hopping on the preferred stock train.
Wayne Anderman CFP® MBA is the founder of Anderman Wealth Partners, based in the Greater Fort Lauderdale Area, and a registered representative of Avantax Investment ServicesSM. Member FINRA, SIPC. Investment advisory services offered through Avantax Advisory ServicesSM.
These opinions are based on Wayne Anderman’s observations and research and are not intended to predict or depict performance of any investment. These views are as of the close of business on 09/30/2020 and are subject to change based on subsequent developments. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. These views should not be construed as a recommendation to buy or sell any securities. Past performance does not guarantee future results.