Some income investors like the dividends of common stock. Others are drawn to the safety and reliability of bonds. Is there an investment that can offer the best of both worlds? Yes, preferred stock, but there are some risks.
First it is a little like common stocks but not entirely. Preferred stocks resemble common stocks in that the investor does get a share of ownership in the company. Preferred stock holders also get dividends. In fact the dividends are generally more on schedule and cannot be easily eliminated as common stocks. And while dividends of preferred stocks are not guaranteed, they have priority over common stocks if the company should run into difficulties. Preferred stockholders also line up ahead of common stock owners to get payment if the company goes bankrupt.
Some companies allow holders to convert their preferred stock to common stock.
These are called convertible shares. This is a nice benefit if inflation rises and erodes the purchasing power of your fixed preferred dividends. You can sell your preferred stock or convert it to common stock.
A disadvantage of preferred stock is that it does not rise as high or as fast as common stock. Their prices change slowly and are linked to interest rates. That’s because unlike common stock, their price is not tied to the company’s profits. While common stock owners are entitled to voting rights, preferred holders do not get voting rights.
Because they don’t grow as fast over time as common stocks, preferreds usually come with higher yields and thus are sometimes more attractive to income seeking investors and those who greatly value income preservation over growth, like retirees. Then again, the price an investor pays is that he or she cannot easily accumulate wealth over the years as with common stock. The bottom line: common stock investors will be treated to larger total returns and more rapid income growth over time.
A Little Like Bonds
Preferred stocks are also a little like bonds., How so? Like bonds, preferred stocks are a form of fixed-income security. The investor receives dividend payments on a set schedule somewhat like bond interest payments. The investor opts for steady and reliable income rather than expects substantial growth. They are issued with a set par or face value.
Preferred stocks also are like bonds in that they have a maturity date. After the date, the company can, if it elects to, buy back shares at par value (the initial issuing price).
In addition, preferred stock is not debt that the company is obligated to repay, like bonds.
Still, while preferred investors receive priority over common stock investors if the firm goes bankrupt or incurs other cash flow woes, they take a back seat to true bond holders.
In addition, preferred stock has a distinct advantage over bonds (except municipals). Preferred dividends are taxed at lower rates than bond interest payments.
At a time when rising interest rates have fixed income investors worried, preferred stock looks like a good bet. It could well be that yields on preferred-stock funds rise ahead of those on high-yield bond funds. Preferreds have regular income at generally higher yield than common stocks, favorable tax treatment but are not necessarily adversely affected by inflation as bonds. Still, they have their downsides such as lack of solid growth potential and less protection than bonds in case the company runs into trouble or declares bankruptcy.
David Beck/ Chasing Income
