Most people have not heard of Preferred Stocks. Those who have, stay away from them because they are not mentioned in typical investment discussions. We feel that is a mistake as Preferred Stocks offer great investment opportunities. Basically, a preferred stock is a fixed income investment similar to a Bond, although the company will list it as equity and not debt. Preferred Stocks have the following features:
- They pay fixed dividends on a regular basis – typically monthly or quarterly. This is different than common stocks where the dividend can go up or down based on what the company decides. Preferred Stock dividends are stated up front and do not change except for ones that use a floating rate dividend. More on that option later.
- They typically have a par value of $25 but there are some with $50, $100, and $1,000 values. Par value is the face value of the Preferred Stock which is used to determine the dividend amount and is also the value the company must pay if they re-purchase it from holders. For instance, if a Preferred Stock has an 8% stated dividend, it will pay $2.00 a year (8% X $25) in dividends no matter what the current trading price of the Preferred Stock.
- They have a “call” date specified in the prospectus at IPO which is the date the company may re-purchase it from holders for the par value. Typically call dates are 5 years after IPO but this can be sooner or later.
- Some have a maturity date which requires the company to re-purchase them but most are perpetual and can go on forever.
- Some have cumulative dividends which means if a company skips a dividend for whatever reason, it accrues and the holder is entitled to any missed dividends at a future date.
- Some have noncumulative dividends which means a missed dividend does not have to be paid in the future. Typically, a company will not use this feature as this kind of stance would impact future access to capital.
- A company must pay dividends to preferred stock holders before paying dividends to commons stock holders.
Here are some more specific details on Preferred Stock characteristics:
- Call Date – This is the date in which the issuing company has the right to repurchase (Call) the Preferred Stock from all the holders at the par value. This is typically 5 years from the IPO date but it could be more or less. If the price of the Preferred Stock has risen over time to be well over the par value, as the call date approaches, the price will normally migrate back down to par.
- Fixed vs Floating rate – At the IPO, the Preferred Stock pays a fixed dividend on a stated schedule for a stated period of time. Typically, the period is monthly or quarterly. Some Preferred Stocks start paying a floating interest rate after a number of years that adjusts based on an index such as the 3-month Libor, the 5-year treasury, or some other index.
- Ratings – Preferred Stocks can be rated by Moody’s, S&P, or other rating agencies if the issuing company wants to pay for this service. Typically, investment grade rated preferred stocks pay a lower dividend than speculative or non-rated ones.
- Current Yield (CY) – The current yield is what an investor can expect to receive in dividends based on the current trading price. If the price is below par, the rate will be higher than the stated dividend and vice versa. For instance, if an 8% Preferred Stock is trading at $27 a share, the current yield is 7.4% ($2.00/$27.00). This fluctuates with prices.
- Yield to Call (YTC) – This is the yield based on the Preferred Stock being called at par value on the call date. As mentioned earlier, if the price is well over the par value, as the call date approaches, the price will normally migrate back down to par. This will create a capital loss to offset the dividends and therefore, the YTC is an important item to monitor, especially when the call date is 18 months or less away
- Yield to Maturity (YTM) – This is the yield based on the few Preferred Stocks that have a maturity date. The issuing company is required to buy back the Preferred Stocks at par and the price will tend to gravitate to par as this date approaches.
Unfortunately, ticker Symbols for Preferred Stocks are not standardized across the different brokerage firms. But once you determine the process used by your individual firm, it will be easy to know the conversion. For instance, a typical ticker for the Series A Preferred Stock from company XYX is XYZ-A. Your brokerage firm and financial sites may use: XYZ-A, XYZPRA, XYZ-PA, XYZ.PRA, XYZpA, or XYZ’A.
Preferred Stocks trade on the NYSE and your brokerage firm normally charges the same trading fees as they do for common stocks. There is a unique feature of Preferred Stocks that is important. It happens during the IPO process when they are first announced. Many Preferred Stocks will trade on the Over The Counter (OTC) or Pink Sheets market for 7-14 days before trading on the normal exchanges. During this timeframe, it has a temporary ticker and can be purchased by many brokerage firms. Sometimes this can be purchased at a price near or below par. Therefore, it is important to know when new issues are being released and when they start trading OTC. We monitor and research upcoming releases and will announce them to members. This can be a great advantage as opposed to waiting until it trades on the NYSE.
The two primary risks in Preferred Stocks include credit risk and interest risk. Credit risk is basically the credit worthiness of the issuing company. If the company appears to be headed for issues and possibly bankruptcy, the Preferred Stock prices are doing to decrease. Interest risk is the risk that prices will fall as interest rates increase (prices and yield go in an opposite direction). This is because investors can get higher yields from lower risk investments such as Government Bonds, CDs, Savings Accounts, etc. There always has to be a delta between risk free and risk investments. If you can get a return of X% from a risk-free investment, how much above X% would you need in order to make it feasible to invest in a risk asset?