Dividends are an essential part of a Boomer’s income stream in retirement. Unfortunately, many stocks that used to pay handsome dividends have either dropped significantly or have been eliminated all together. One solution as an alternative is investing into preferred stocks. What exactly are preferred stocks? Preferred stock are typically considered to be “hybrid” investments. No, we’re not talking about a more fuel efficient stock. Hybrid in that they have characteristics of stocks and bonds. Let’s look at what the pros and cons of preferred stock.
Preferred Stocks and Dividends
As the “preferred” adjective implies, these shares are a step above common stock. If you own preferred stock in a company, you will get your dividend first; all the common shareholders will get theirs second. You also have preference if a corporation declares bankruptcy or liquidates and sells assets. In that instance, debt holders are paid first, then the preferred shares, and finally the common shares.
Priority on Dividend Payments
Dividends paid out on preferreds are akin to coupon payments on a bond. A preferred stock obviously doesn’t have a maturity date like a bond, but it does have a par value, which is used to figure out the payouts. You determine the preferred dividend by multiplying the preferred dividend rate percentage by the par value.
If you need to figure out the market value of a preferred stock, you can do that simply. Divide the dividend amount by the yield (required rate of return stated by the issuer). A visit to a stock research website will give you the yield percentage on a preferred.
Similarly, the price of a preferred stock equals the preferred dividend divided by the yield percentage.
Sometimes a corporation can’t pay dividends to preferred shareholders. If that’s the case, the company will often let the preferred stock dividends accumulate until cash flow improves.
Types of Preferred Stock
Most preferred stocks are cumulative – that is, any missed dividend payments accumulate for an eventual payout. Most preferreds are also callable – that is, the stock issuer has a chance to call (redeem) the shares at par value. Yields on preferred shares sometimes include premiums in recognition of this risk.
Some preferred stocks are convertible, with embedded options allowing you the chance to exchange preferred shares for common ones. (Sometimes a provision is allowed that gives the issuer the chance to call for the conversion.)
Some preferreds are participating – when a company does well, the dividends from these shares may be greater than the published yield.
Finally, when a corporation issues multiple rounds of preferred stock, there may be preference-preferred shares; if you own shares from the first issuance, your preferreds take priority over preferreds issued later.
Downsides of Preferred Stock
What is the downside of owning a preferred stock? Well, they do present potential and actual disadvantages. When a market sector heats up and common shares take off, preferreds often lag behind. Interest rate hikes can reduce the value of preferred shares. Additionally, you have no voting rights as a preferred shareholder, there may be a limited market and call risk for these securities.
Ratings. There is no “official” rating system for preferred stocks; however, the big credit agencies that rate bonds rate preferreds as well. Standard & Poor’s and Moody’s do, and when they downgrade, it can hit a preferred stock hard. Preferred stocks rated beneath BBB- at Standard & Poor’s or beneath Baa3 by Moody’s are considered junk preferreds.2 If you have to go outside of S&P or Moody’s to find a preferred stock’s rating, that’s a red flag – it might mean that it couldn’t get a decent rating from S&P or Moody’s.
A preferred stock investor would do well to research a company’s financial ratios and cash flow, and its interest coverage ratio (higher is usually better).
Few Examples of Preferred Stock
Most major companies will have some sort of preferred stock. Take Ford (Symbol:F), for example. You can purchase PIJ, a 7.4% Ford preferred. If an individual stock is too risky for you, you can consider an ETF that tracks the Preferred Stock Index. IShares released the US Preferred Stock ETF Symbol: PFF. As you can see, there are plenty of options to choose from.
Weigh Your Options
Preferred stocks have looked attractive to retirees and others seeking consistent dividends. Rather than explore them alone, you should see a financial consultant who can help you thoroughly understand your options in this area and compare them to other choices you may have.