What are preferred stocks and how do they work?
To understand preferred stocks one must think of them more as bonds than stocks. They are a form of debt. Calling them a stock and paying dividends rather than paying interest means that for some preferreds the owner has Qualified Dividends. Since a preferred stock is debt rather than equity, the holder does not have voting rights.
Preferred stocks comprise a minimal 1% of the domestic stock market. They don't make sense to a stock investor and bond investors think they are stocks. The limited trading creates opportunity for the smaller individual investor.
The way they work is that the buyer has a contract to receive a specific dividend rate times par of $25 (for the ones we buy), usually running for five years from the date of issue. If we buy one on the stock exchange or secondary market that was issued two years ago, it has three years to run before becoming callable and the company can buy it back for $25 per share. The price to buy or sell is not material to the company, as it has to buy it back at par of $25 to remove the debt obligation.
However, preferred stocks do not have to be called and can run for years, in which case if we don't sell we are stuck with the same fixed dividend dollars. Some preferreds have a feature of a rate that floats a specified amount after becoming callable, typically about 5% above a discount rate. The float provides some inflation protection to the owner.
About half the preferred stocks under my management are callable. In the last few years very few are called. The reason for a call is typically an acquisition or a dramatic shift in company cash flow and desired debt. We have had some trading for under $20 that were called for the $25.
The 1,100 preferred stocks in accounts I manage have a median price of about $20. That means if the dividend is 8% but we pay $20, we have a Yield on Cost of 10%. If it is not called, we are stuck with the 10% unless there is a floating feature.
Another key metric is Current Yield, which is the yield based on the current price.
With falling interest rates, the price may go above the $25 par. The selling decision at that point is to balance a high dividend against receiving $25 per share when called. An Excel formula calculates the Yield to Call. If a preferred is selling for $26.50 the $1.50 above par is apportioned over the time remaining to call and weighed against the dividend rate.
Most preferreds pay dividends quarterly.
Preferreds can be cumulative or non-cumulative. Cumulative means that the company can defer or suspend the dividend, but then have to make it up at a later date. Dividends on common stocks are prohibited if the preferred dividends are deferred. Since dropping a common dividend dramatically impacts the price of a common stock, deferring dividends is usually a last resort.
Bank issued preferreds are not cumulative and generally have lower dividends. Prior to the banking crises of 2009 most preferreds were issued by banks. There were tax advantages to the issuer in going through a bank. That changed when the rules were changed for bank capitalization tiers.
I create my buy list from CDx3, a preferred stock data provider. Their research found 10 criteria associated with higher and more stable returns. These are factors such as a $25 par, cumulative dividends, a domestic company, dividends above 5%, and having an industrial rating. I usually require at least a score of 8. Having an industrial rating lowers the dividend by about 4%. I don't find industrial ratings that reliable (Enron) and use other measures to evaluate quality such as the fundamentals of the issuing company. If the common stock price is falling dramatically more than the market, I often sell before the preferred stock price follows suit.
On my buy list I sort by descending Current Yield. I usually like to have a mix of higher dividends with higher risk and lower dividends with lower risk. Once I've evaluated the preferred, I then study the quality of the common stock. When buying common stocks one is looking for price appreciation. The framework for buying preferred stocks is entirely different. What I look for is if the company is sound and likely to continue to pay its dividends. I don't care about whether the common stock is going up. If the price of both the common and preferred come down, but are not pointing to insolvency, that is to our advantage in buying the same income at a cheaper price.
Of about 125 unique preferred stocks that I manage, there are usually three or four in trouble. The high dividends can cover that, and the vulnerability is reason to buy a portfolio of at least twenty positions. The average is about thirty-five per client.
About half the preferreds I manage have been issued by REITs which issue preferreds as preferrable to mortgages. Preferreds issued by REITS do not have qualified dividends, while most other preferred stocks have qualified dividends. Therefore I try to put the REIT preferreds in the IRA accounts.
Mixed in with the preferred stocks are notes or baby bonds. They are like preferred stocks with the exception that there is a maturity date when they will be called. Notes give some protection against a long-term price decline and future needs for withdrawals.
Preferred stocks should not be considered a short-term investment. They should be bought for the income. In our home, my desk has been in this same corner for fifty years. The value of the house has changed, but that is background to our daily experience of living in the house. Price fluctuations are interesting background while the main consideration for the investment is what it can do, that is produce income. I struggle to have clients look at the income rather than the supposed value of their accounts.
All of this will come into focus better by studying my performance reports. If you look at several you will see that the format has been evolving.