Savvy Investors Prefer Preferreds

July 8, 2010 | By Steven DiGregorio

Shares of Preferred Stocks offer corporate bond-like yields plus potential gains.  Sound attractive?  Let’s take a closer look.

Although bought and sold like common stocks, preferreds are more similar to bonds. They represent debt, not ownership in the corporation. They’re called preferred because a firm must pay its preferreds’ dividends before paying common stock dividends. During periods of market volatility, many investment-grade preferreds can possibly pay dividend yields higher than some bond coupons.

Like bonds, corporations issue preferreds to raise cash. At the IPO, the issuing firm sets the issue price, typically $25, and the annual dividend (usually paid quarterly), which generally remains fixed for the life of the preferred. The initial dividend yields (coupon rate) can range from 4% to 7%, depending on the market.

Because preferreds trade on the open market, the share prices vary with supply and demand. If the shares trade below the IPO price, the yield to new investors (market yield) moves above the original coupon rate, and vice versa, similar to bonds.

Preferreds have minimum 30-year maturities and some are perpetual, meaning that the issuer is not obligated to redeem them. Most preferreds are “callable”, meaning that the issuer has the right to call or redeem them at the “call price” on or after a specified date (call date), typically five-years after issue. The call price is usually the original issue price, but is sometimes slightly higher.

The issuer is not obligated to redeem the shares at the call date. Companies are most likely to call preferreds if prevailing interest rates are below the coupon rate. If so, they would save money by calling the existing shares and selling new preferreds paying lower rates.

Investors meanwhile, purchase preferreds mostly for the steady income. They usually don’t offer much appreciation potential. However, market volatility can create opportunities.

Before the IPO, the issuer designates the preferred dividends as “cumulative” or “non cumulative.” If cumulative, the issuer is obligated to pay the dividends. If it suspends the payouts, it still owes the money and must catch up by the maturity date, when it calls the shares, or before it pays dividends on its common stock. If non-cumulative, the issuer doesn’t have to make up missed dividends.

Corporations that issue preferreds typically sell more than one series, for instance, Series A, Series B, and so on. Unlike regular stocks, there is no fixed ticker symbol format for each series. Different websites and brokers might use different symbols for the same preferred. W

Let’s talk Yield to Call

Unlike market yield, which simply reflects the annual dividend and current trading price, the “yield to call” takes the call price and call date into account. For example, say that you pay $26 per share for 7% (coupon rate) preferreds originally issued at $25 that can be called in 12 months. The market yield is 6.7%, but you would lose $1 per share if the shares were called. If called in 12 months, your total return, or “yield to call,” would drop to 2.9%. Conversely, if you bought the same shares at $24 one year before the call date, the yield to call would jump to 11.5% if called in 12 months.

Successful preferred investing requires understanding the issuer’s ability to pay the prescribed dividends.

With banks paying next to nothing on money market accounts, this a good time for income-oriented investors to consider preferred stocks.  While these tools are clearly not meant for every investor, they provide a unique income strategy coupled with the added benefits of potential appreciation and complement a well thought out diversification strategy.

For more information contact us at 845.563.0537 or Contact@CompassAMG.com

The author of this blog, Steven M DiGregorio is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC a Federally Registered Investment Advisory Firm.  Securities offered through an affilliated company Spire Securities, LLC a Registered Broker/Dealer and member FINRA/SIPC.

 

Tags: bonds, ETFs, Exchange Traded Funds, growth, high yield, investing, investment strategies, investments, IRA, portfolio, preferred stocks, retirement, retirement income, rollover IRA, ROTH, stocks

STEVEN M DIGREGORIO is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC.
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