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Is This the Time to Develop a Preference for Preferred Stocks?

Not unless you really understand this special class of securities and how they work.

Helen Modly, 09/07/2006

Preferred stocks have always been attractive to individuals seeking higher yields than are usually available with common stocks or investment-grade corporate bonds. Their complexity in structure and the significant ways they differ from each other all but guarantee that most holders of these securities don't understand what they own. Knowing more about preferred stock will help you to determine if they have a place in your clients' portfolios.

Preferred stock differs from common stock in a couple of important characteristics. Holders of preferred stock take precedence over holders of common stock in the event of a corporate liquidation or bankruptcy. They still fall behind creditors, bondholders, and even employees, so this may not amount to more than a few pennies on the dollar in such an event.  Also, preferred stock is usually non-voting stock, meaning that you won't be attending any shareholder meetings.

Looks Like a Bond, Acts Like a Bond.

The primary advantage to preferred stock is that it is commonly issued with a fixed dividend much like a bond is issued with a fixed coupon. Generally, this dividend is higher than that paid on the issuer's common stock and, unlike the common stock dividend, is usually guaranteed. Because of this fixed dividend, preferred stock acts more like a long-term corporate bond than its common stock cousin. Most preferred stock is issued with maturities of 30 years or more, and some issues are perpetual, meaning there is no maturity date. This makes preferred stocks more volatile than short-term obligations. These shares are more sensitive to interest-rate changes and the credit rating of the issuers than to the regular day-to-day swings of the overall equity markets.

Most preferred stocks also have call provisions that allows the issuer to call the shares at any time or after five years. If interest rates go up, the value of your shares will decline, just like a bond. If interest rates go down, the issuer will likely call your shares before you can enjoy any real gain. Academics call this type of "heads I win, tails you lose" behavior "negative convexity," and it is one of the reason preferreds have to offer higher yields to be attractive.

Traditional Preferred

There are two main classes of preferred stock. The traditional preferred stock was the only form until the 1990s, when trust preferred stock appeared. Traditional preferred stocks are perpetual in nature, thus have no stated maturity date. The dividends are usually fixed, although there are some issues with adjustable dividend rates. They are usually callable anytime at the issuer's discretion or after five years from the date of issue. The dividends from most traditional preferred stock are taxed at the qualified dividend income rate of 15%. The major exception is the dividends of preferred stock issued by REITS, which are not eligible for the 15% rate. There is no inflation protection (with the possible exception of those preferred shares with a variable dividend) since the dividend is fixed.

Traditional preferred stocks are very thinly traded and generally have a dividend yield slightly lower that the trust preferreds. This is because the dividends from these traditional shares usually qualify for the 70% exclusion on dividends received that many U.S. corporations receive.

Trust Preferred

Trust preferred stock is by far the more prevalent form of preferred stock issued today. It is usually issued by bank holding companies who do not want to add additional debt to their balance sheets, nor do they want the diluting effect of issuing additional common stock. Another major advantage to the issuer is that the dividends paid on trust preferreds is deductible to the corporation, while dividends paid on traditional preferreds are not. This is due to a hybrid arrangement where the company uses a trust to pair the issuance of preferred stock with the purchase of debt securities. In essence, the issue of trust preferreds represents a borrowing by the company. This results in the dividends paid by trust preferred stock not being eligible for the 15% tax rate or the corporate exclusion for qualified dividend income. 

Most trust preferreds have maturity dates of 30 to 50 years and are generally callable. Trust preferreds are senior to the issuer's traditional preferred stock and common stock, but junior to the company's senior debt.

Convertible Preferreds

These are truly a hybrid security. They have all the characteristics of preferred stock, with one additional twist. At the owner's option, these shares may be converted into shares of the company's common stock at a preset conversion price. If the company's stock is trading at or above this price, then the preferred shares will begin to behave more like the company's stock than a bond. If the common stock is trading below this conversion price, then the preferred shares will behave more like a bond.

Most convertible preferreds also carry the right for the issuer to force conversion of the shares to common stock whenever the price of the common stock equals or exceeds a specified price for a specified number of days, usually 20. Since convertible preferreds offer some opportunity for capital appreciation, they usually pay a slightly lower dividend than non-convertible preferreds.

Other Differences

Preferred stocks may be participating or non-participating. A preferred stock that is participating may receive additional dividends over and above the stated dividend when the company pays dividends to shareholders of its common stock. This allows preferred stockholders to share in the ongoing good fortune of a successful company.

Non-participating preferreds will only pay the stated dividend, regardless of the dividends paid to common stock shareholders.

Preferred stock may be cumulative or non-cumulative. Cumulative shares provide the owner with an ongoing claim to skipped dividend payments. If the company misses one or more dividend payments, then the cumulative shareholder has the right to receive these missed dividends before any dividends can be paid to shareholders of the company's common stock. Owners of non-cumulative shares do not have this right. A missed dividend is gone forever.

Preferred stock in general is relatively thinly traded and since there are no standard ticker symbols for these shares, it is often difficult to find much information about a specific issue other than what is provided by the issuing company.

Planning Issues

In a stable interest-rate environment, especially when rates are relatively low, preferred stock can be an attractive alternative to corporate bonds, especially when the dividends from preferred stock qualify for the 15% tax rate.  However, when interest rates are rising, the price of these shares will be even more inversely affected than long-term bonds. When interest rates are falling, these shares will likely be called away, thus forcing the investor to re-invest principal at lower interest rates.

Advisors must be able to weigh the advantages and disadvantages of these hybrid securities in order to determine if they are appropriate for any given client portfolio. The juicy dividend yields hide a considerable amount of risk that may or may not make sense in a given scenario. For clients who want the stability and predictability of a bond ladder with high quality bullets, these securities contain too much optionality in favor of the issuer. For clients with a total return focus for their fixed income portfolios, preferred stocks may be appropriate for a piece of that allocation. In either event, be sure you understand how these securities are likely to behave before you recommend them to your clients. This is one of those securities where it is critical to read the prospectus before you buy.

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