Is Preferred Stock a Happy Medium?
Preferred stocks occupy the middle ground between bonds and common stocks. Like bonds, they pay out regular interest or dividend payments; like stocks, they retain the potential for upside capital appreciation. On the capital structure ladder, again, they stand halfway. In any bankruptcy, when all creditors line up for asset priority claims, preferred holders are repaid after bondholders and before stockholders.
So why do individual investors gravitate toward common rather than preferred stock? They tend to shy away from the latter class partly because information about it can be more difficult to obtain and understand. As a result, the benefits of preferred stock are often overlooked. If you are unfamiliar with these hybrid securities, work with financial professionals to see if they are right for you.
Should you prefer preferred stock?
Preferred stock comes in several flavors, which tend to have either long maturities (30-50 years), or in perpetuity with no maturity or fixed end date. If that sounds like a no-brainer, consider whether you would be willing to buy a 100-year bond at the same rate of interest as that of preferred stock. Possibly not.
Here are various types of preferred to distinguish among:
- Cumulative — Owners can receive dividends late in arrears. (Better late than never!)
- Noncumulative — Dividends may be slightly higher to compensate for the lack of protection for unpaid dividends offered by cumulative.
- Participating — Owners may receive more in liquidation.
- Convertible — Holders can exchange their preferred for common stocks at a specified conversion ratio.
- Adjustable rate — Flexible preferred share payouts are tied to benchmarks like Treasury bill yield.
- Callable — Issuers can redeem shares at a preset price, and owners receive a premium for reinvestment risk.
Preferred shares generally fluctuate in a tighter range than do their common stock cousins, driven mainly by interest rates and the credit risk of the issuing company. They carry their own credit ratings too. They are more transparent, however, than bonds, and purchase is straightforward, through exchange-traded funds and mutual funds. If they are trading only a few thousand shares a day, however, low liquidity can lead to wide bid/ask spreads.
The organization’s viewpoint
Now step into an institutional mindset. How would you, as an issuer of preferred stock, see it? It is often valuable to consider your investments from the company’s perspective for an all-around assessment.
First, remember that preferred stock counts as equity on the balance sheet, unlike bonds, which are considered debt. Financial companies in particular issue preferred stock, but so do telecoms, real estate investment trusts, and transportation and utilities businesses. All these might use preferred stock rather than bonds to raise capital, which helps reduce their debt-to-equity ratios. Lenders encourage a lower ratio, which lessens the risk of loan defaults; shareholders approve too, perceiving less likelihood of bankruptcy. Companies can also defer preferred dividend payments when cash flow is tight, although bond issuers, by contrast, remain on the hook.
An advantage for issuers of preferred versus common stock is eliminating the danger of a hostile takeover, since preferred stockholders cannot vote. Flexibility is another plus. When interest rates decline, issuers may be able to call the preferred stock and substitute a new issue with a lower rate or replace it with debt or common stock.
To whom do these corporate issuers mainly sell? Other institutions! Because organizations usually buy in large quantities, they are likely to quickly scoop up more shares.
Neither fish nor fowl
Which should you choose? Common stock has more upside, with potential for significant capital gains. On the other hand, preferred securities can provide a stable, predictable, long-term passive stream of income. Preferred dividends are higher than those for common stocks, and holders enjoy dividend priority; in times of stress, common stock dividends must be suspended first.
Proponents of common stock cite voting rights, which preferred holders do not share. But if you are not concerned with directing a company’s future and you might not vote anyhow, that power has little importance.
The decision is an individual one, depending on your cash flow needs and overall portfolio. Talk to your financial adviser about which class of stocks might best suit your portfolio, risk profile and cash flow needs.