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Q&A: What are preferred stocks, and should I invest in them?

Kent Grealish
by Kent Grealish, The Garrett Network  (@KentGrealish)

Preferred stock is a hybrid – a cross between common stock and bonds. While considered equity (ownership), preferreds act more like bonds, paying a fixed dividend and callable (redeemable) at the company’s option.  

It is labeled “preferred” because it stands ahead of common stock (although behind bonds) when it comes to payment of dividends or in liquidation.

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While this might make preferred stock slightly safer than the common, preferreds also carry the same risks as bonds but with less protection.

The fixed dividend exposes preferreds to bond risks such as duration/interest rate risk (prices fall when rates rise), inflation risk, credit/default risk, and call risk. With no maturity date, preferreds act like the longest maturity, most junior (lowest quality) bond of the same company.   

If interest rates fall sufficiently, preferred stock can be called which means shareholders must reinvest proceeds at prevailing (lower) rates. So investors should not buy preferreds trading much above their call price.

If interest rates rise because of inflation, preferred shareholders lose in two ways: through falling share prices and through the dividend’s decreased purchasing power.

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But companies can increase a common share’s dividends making it possible to maintain the common stock’s purchasing power during inflationary periods. 

So although preferred stocks initially pay bigger dividends, if the company regularly raises the common dividend (and shares are held long enough) the common payout could eventually surpass that of the preferred.

Compared to bonds, exchange-traded preferreds are more liquid, have greater price visibility and can be purchased in smaller amounts. They also have higher yields than bonds but this reflects the greater risk they carry.

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So, to answer your question:

You should invest in preferreds if you want more income (although with higher risk than investment-grade bonds), if this will be a small portion of a reasonably well-diversified portfolio, and if you are careful not to pay a huge premium to the call price (be sure you know all call provisions).

 

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Kent Grealish, CFP®, AIF® Partner in Quacera LLC, has served clients as a financial advisor for over three decades. Kent specializes in helping clients construct and manage personal investment portfolios and retirement accounts.