Preferred stocks are oft overlooked securities that have interesting qualities of both stocks and bonds. While common stocks are the preferred investment vehicle of most risk investors, and bonds are the domain of risk-averse income seeking investors, preferred stocks are a mixture (hybrid if you will) of fixed income securities and common stocks. The best way to think of preferred stock is as a financial instrument that has characteristics of both debt (fixed dividends) and equity (potential appreciation) much like the Centaur is half man half horse. Preferred stocks also are known as “preferred shares”.

So what is a preferred stock anyway? It’s capital stock, issued by a corporation, just like its better known counterpart, so-called common stock. But unlike common stock, preferred stock doesn’t participate in shareholder votes, and it doesn’t normally benefit (or suffer) from changes in earnings.

Like a bond, preferred stock pays a fixed cash payment. If companies have enough money to pay the preferred dividend, they must do so. Prices of preferred stocks also trade similarly to the prices of corporate bonds. At the same time, preferred stocks are stocks, in that companies may suspend the preferred dividend if they hit tough times. And, like common stock, preferred stock doesn’t give owners dibs on assets if the company fails and liquidates.[1] (USA Today)

Most preferred issues technically exist forever. That means you take on some interest-rate risk — your stock will drop if interest rates rise. Unlike bonds, which will be paid back at face value eventually, high interest rates could keep preferred stock prices low for a long time.

Thus, there are both pluses and minuses when considering preferred shares for investment. Preferred shareholders have priority over common stockholders on earnings and assets in the event of liquidation and they have a fixed dividend (paid before common stockholders), but investors must weigh these positives against the negatives, including giving up their voting rights and less potential for appreciation than common stock.[2] As well, preferred stocks have greater price stability than common stocks and greater liquidity than corporate bonds of similar quality. Other considerations, the lack of specific maturity date makes recovery of invested principal uncertain and appreciation potential is limited. (Investopedia)

What are some of the common indenture terms for preferred stock? Preferred stock may or may not be “convertible,” giving shareholders the right to take an ownership stake in the company by allowing them to convert preferred shares into common shares. Convertible preferred includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date. As well, the dividend payment can be either cumulative or noncumulative. In the case of cumulative preferred, a provision in the shareholder prospectus will stipulate that if any dividends have been omitted in the past, they must be paid out to preferred shareholders first, before common shareholders can receive dividends.

Who are the primary issuers and purchasers of preferred stocks? Businesses and corporations, such as utilities and banks, that rely heavily on debt financing are the primary issuers of preferred stocks. The equity of highly leveraged firms tends to carry greater financial risk premium (risk of default). As a consequence, the equity is valued at a discount to where it might trade if the firm was not so highly leveraged. Under this scenario, managers do not like to issue equity at a perceived discount. However, they can run out of room in their capital structure for issuing debt. At some point, it becomes too expensive to issue debt. As an alternative to debt and equity, these businesses issue preferred stock.

The natural buyers of preferred stock are corporations. IRS rules allow U.S. corporations that pay corporate income taxes to exclude 70% of the dividend income they receive from their taxable income. This is known as the dividend received deduction, and it is the primary reason why investors in preferreds are primarily institutions.

So…why would an individual investor care to own them? In her article entitled “Uncovering Preferred Stocks“, personal finance expert Jennifer Openshaw claims there are three reasons:

High, steady yield. Because they are subordinate to bonds, and because their existence may be indefinite (no required date for a company to pay back, for most), their yields are higher. For high-quality issues, effective yields can run 5.5% to 6% and higher.

As investors pull back from chasing higher junk-bond yields, preferreds make more sense as an alternative. Also worth noting is that most preferred dividends are paid quarterly, whereas bond interest is only paid twice a year.

Better tax consequences. According to fixed-income portal QuantumOnline, dividends for more than half (some 536 issues in all) pay qualified dividends — that is, they are subject to the 15% maximum tax rate. Especially since that rate survives AMT, qualified preferred dividends can have tax advantages for high-income recipients.

Exchange traded. As obscure as preferred stocks are, the bond market is hardly any better. At least most preferred stocks trade on major exchanges, usually in smaller $25 increments instead of the $1,000 increments typical of bonds.

Those are the pros — now here (according to Openshaw) are the cons. First, because they are hardly a consumer investment product, preferred stocks are notoriously hard to research. QuantumOnline is the best site and is free (you do have to register). Another portal, ePreferreds Online, offers a nice tool but charges $29.95 a month or, more handily, $10.49 for a single-day use.

Preferred stocks are issued in many varieties and flavors. Although in principle all preferred stocks are a variation on debt and equity, terms specific to an individual issue can vary significantly. Some of the basic features and types of preferred stocks include callable, cumulative, participating, convertible, and adjustable rate. Therefore, when buying preferreds, it is important that investors read the offering prospectus issued when the shares IPO. If you are not comfortable diving into prospectuses or indenture agreements in order to identify promising preferred stock investments, you might want to consider a mutual fund or ETF that specializes specifically in preferred holdings for investment.

If you decide to do it yourself, as mentioned above one place to find out which preferred shares are available is Income Investing Information at quantumonline.com. The site is free, but you need to register. Another way to invest in preferred stock is by buying a basket of them through an exchange-traded fund (ETF). The S&P U.S. Preferred Stock Index fund (PFF) owns the preferred stocks in the S&P index.

As a rule of thumb, cumulative preferred stocks trade 50 to 75 basis points over comparably rated corporate bonds and noncumulative preferred stocks trade another 100 to 150 basis points over cumulative preferreds. By going from corporate bonds to quality rated noncumulative preferred stocks, investors may be able to pick up as much as an additional 200 basis points in yield in today’s market.

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

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[1] “Preferred stocks provide income, but they’re not bonds,” Matt Krantz, USA Today, August 16, 2007. http://www.usatoday.com/money/perfi/columnist/krantz/2007-08-16-preferred-stock_N.htm
[2] Preferred stock, Investopedia, http://www.investopedia.com/terms/p/preferredstock.asp