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Preferred Stock: The Worst of Two Worlds

Jeremy Glaser

Jeremy Glaser: Does it make sense to invest in preferred stock? I'm Jeremy Glaser for Morningstar.com.

I'm here today with Morningstar DividendInvestor Editor, Josh Peters, to see if there's room for preferred in investor's portfolios. Josh, thanks for joining me today.

Josh Peters: Happy to be here.

Glaser: A lot of investors, in this zero-yield environment, have been looking at preferred, having been asking us about preferred. So, first off, what are preferred stocks?

Peters: Well, preferred stocks are, in a lot of ways, kind of anachronistic. You look at capital structures of corporations going back into let's say the late 19th century, there was almost always a preferred stock.

A little layer there between the last of the bond holders and then the most junior claims on any kind of a corporation, which is its common stockholders.

What they are is, from the standpoint of a common equity holder, it's a fixed obligation, so it looks kind of like debt.

From the standpoint of a bondholder or a bank or some other kind of creditor, it looks like equity, since it's behind them in line to get paid.

So, in a lot of ways, these are securities that kind of combine the worst of both features [laughter] .

You don't have that protection of a contractual claim that you have with a bond, yet you don't have any opportunity to grow with traditional preferred stocks, any way to grow your income, the way that you would with common stock.

Glaser: Suffice it to say, it doesn't sound like you're a huge fan of preferred shares?

Peters: No, I try to look at them the same that Ben Graham did. He wrote that these securities were really inherently flawed, relative to both bonds or common stocks.

But if you could pick them up on a bargain basis, you weren't paying full price, you were paying a big discount - as I was able to do last summer with a couple of preferreds in our Dividend Harvest Portfolio - then they might be worth a shot.

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Glaser: When you did buy them in July, what was your thought process? How did you weigh the risk and reward to actually decide to go into these?

Peters: Well, the way I wanted to look at it is that my biggest risks were credit risks, that the issuer just might go bust, and not be able to pay me my dividends.

And then, second really, extension risk, that if interest rates go up, these issues may never be called back, they will never be redeemed, they don't mature contractually the way a bond does.

I could be stuck with it forever at what could be a very low nominal, and a very low real, rate of return going forward.

So the way I looked at it was to look for those discounts. Most preferred stocks are issued at a par value of $25.00. I was able to pick up a few for less than $20.00 with some yields above nine percent.

At the time, I thought that was a pretty good trade off. Even though I was going to get some income growth, I thought there was room for these securities' credit quality to improve.

If inflation didn't get too bad, I could collect a big income without taking what I felt was a whole lot of that long-term risk.

Now, with most preferred stocks yielding kind of in the sevens, seven percent area, or seven to eight percent area, for yields, that risk-reward trade off just is kind of missing.

And you could get stuck owning something for a very long time that is not going to provide you with a decent return.

Glaser: Considering the near zero percent you're going to get on a money market, or the relatively low yield you're getting on a lot of short-term bonds right now, that seven or eight percent can sound pretty attractive.

What would you say to investors who say, well, even if this isn't going to be a great investment, it's better than what I can get elsewhere, and they'll just pile money in?

Peters: Well, I think the important thing to remember is that interest rates aren't going to stay this low forever.

And as interest rates move up, the value of a preferred stock, that might have a seven percent or eight percent yield right now, is going to go down.

It's price is going to have to fall in order to compensate for the fact that there's more competition out there providing better yields.

And you're not going to get any kind of income growth to offset the inflation that is going to erode the purchasing value of that dividend over time.

One example I found, really just outstanding, an issue of the Kansas City Southern Railroad. It was issued in 1962 at $25.00 a share with a $1.00 a share dividend rate.

This was a 4% preferred, because that's what people thought was acceptable at the time. Well, between 1962 and today, inflation has probably completely erased that original four percent dividend yield. You've earned nothing.

And, in fact, that $25.00 has been. Stock trades for less than that today. It trades for less today than it did in 1962.

So you let a fixed income instrument like this, that has essentially an indefinite life, be owned through a period of inflation and high interest rates, it can really destroy a whole lot of value in a portfolio.

So you have to be very careful in how you would use these. My advice is if you can't get them on a bargain basis, don't buy them at all.

Glaser: Josh, thanks for joining me.

Peters: Happy to be here.

Glaser: For Morningstar.com, I'm Jeremy Glaser.