Are Preferred Stocks Safe?

Preferred Shares, Technical Analysis, U.S Investments

I’m still angry! I recently wrote about our “capitulation”. Tim Plaehn explained:

“The yield for passive investors in fixed income products is terrible. Savers and retirees start looking for other ways to make their money grow. Just like you and Jo, many investors have moved into stocks out of necessity rather than desire.” (Emphasis mine)

Tim was polite. Why the hell does the government bail out the banks with stupid low interest rates forcing retirees to put money at risk to earn enough income to live? I’ve complained about this for a decade, it’s not going to change. As my wife Jo said, “Get over it and on with the job.” My response, “Yes dear! I know you are right.”

How does an investor risk the least amount of capital to garner decent returns safely, and sleep well at night?

Tim Plaehn, editor of The Dividend Hunter suggested:

“I divide my recommendations list into different risk categories. One is quite conservative, while still offering investors very attractive yields. Over the last few months, I’ve increased the number of preferred stocks on the recommendations list….”

Several readers wrote asking for more information about preferred stocks. I phoned Tim. He pointed out, there are some excellent, safe preferred stocks providing acceptable yield, and there are some that pose very high risk.

Investors need to understand the basics of preferred stocks, before we start looking at candidates.

What are preferred stocks?

Investopedia tells us:

“The term “stock” refers to ownership or equity in a firm. There are two types of equity – common stock and preferred stock. Preferred stockholders have a higher claim to dividends or asset distribution than common stockholders. The details of each preferred stock depend on the issue.”

That’s not much help. Let me explain it the old-fashioned way.

Assume a company needs to raise money. Generally, they can do so in three ways.

  • Issue more common stock
  • Borrow money by issuing bonds
  • Issue preferred stock

Let’s review the pros and cons of each method and how they affect the company, potential investors and current stockholders.

Issue more common stock. The market price for a stock is based on how investors feel about future profits of the company. If expectations look good, their stock is in high demand.

Should they announce they are issuing more shares, existing shareholders will not be happy as their ownership in the company will be diluted. While demand may be high, the supply of available stock increases and the market price is likely to go down.

The common metric for measuring company performance is earnings per share (EPS); dividing the earnings by the number of shares of common stock outstanding. Unless the additional capital will quickly increase earnings, the EPS will go down.

Low interest rates lured many foolish companies to borrow money to buy back their stock when the share prices were at all-time highs. That reduced the number of outstanding shares, made the EPS look good, stockholders happy, and they got nice bonuses for doing so. They may have earned less money, but they still partied. Buying back stock with borrowed money to improve EPS creates the illusion of prosperity.

Now those bonds are coming due, business conditions are poor, and they are faced with the consequences of those faulty decisions.

Borrow money by issuing bonds. Corporations (and governments) issue bonds. They put an offer to the public saying they want to borrow a certain about of money, the interest rate they will pay, and a date when they will repay the lender. They use the term “par value”, which is the face amount of the bond and what will be redeemed when they come due. (Think of the old $100 savings bond.)

Lenders buy the bonds, collect their interest, and expect to be paid back at face value on the due date.

Bonds are graded by agencies regarding their risk level and are regularly traded. The aftermarket value of bonds varies based on interest rates, corporate performance and default probability.

Several major companies like Ford were downgraded to junk status. The market prices in potential default and bondholders could suffer significant losses. When the bonds come due, Ford may wish to re-borrow and roll them over, and will pay a much higher interest rate to do so.

Companies may prefer not to issue bonds, much like an individual not wanting to use up their entire credit line at a bank.

Issue preferred stock. Preferred stock has many advantages for the issuing company. Preferred stocks are a cross between stocks and bonds.

The issuing company has a face amount, generally $25 per share. Like most bonds, preferred stocks are callable, meaning the company has the right to call in the stock, and pay the investor $25/share at specified times outlined in the offering. Instead of interest, they guarantee a dividend yield. If dividends are $2.50 annually, the yield is 10%.

Why would a company issue preferred stock?

Unlike bonds, there is no due date. Companies can issue preferred stock and never redeem it. It’s similar to an interest only mortgage, they keep paying the dividends regularly, while not having to worry about paying the money back.

They can raise capital without it affecting their line of credit, nor does it affect the EPS calculation. The EPS calculation is based on the number of common stock shares outstanding. Many top-level executive bonuses are based on EPS. Preferred stocks do not dilute the share count and protects their bonuses.

Why would an investor lend a company money with no guarantee of it ever being returned?

Companies are competing for capital with stocks, both government and corporate bonds, and alternatives like Certificates of Deposit. Investors want safety and yield to more than offset their risk. What’s in it for the investor?

Generally, the dividend yield would be higher than a bond. This compensates for the fact there is no guarantee of ever getting your investment capital back.

Investors can sell their preferred stocks in the open market; thousands of shares are traded daily. It’s generally much easier than trying to sell a bond on the open market.

Prices are affected by current interest rates. Some preferred stocks are priced higher than face value. In an investor buys them, they run the risk of having the shares redeemed and losing money. Conversely, some preferred stocks are priced below face value. This may be a result of the company performing poorly, changes in interest rates or market conditions. When the market crashed in early 2020, many preferred stocks dropped well below par value.

Here is the biggie for investors…. Preferred stock dividends are “guaranteed” by the company.

Companies are not obligated to pay dividends on common stock. Many have recently cut their dividends. Preferred stock dividends must be paid ahead of common stock dividends.

One company cut their common stock quarterly dividend from $.40/share down to $.02/share, yet they still pay their preferred shareholders $.55/share.

In addition, preferred dividends are cumulative. For example, if a company guarantees $.55/share and could only pay $.25/share; they must catch up and pay all guaranteed preferred dividends before they can pay out any dividends on common stock.

When the company cut the dividend, their stock price dropped from a high of $26.25 down to $6.40 as people panicked. Six months later it is priced just under $20.00, and the current yield is a tad over 11%.

Tim explained, depending on the type of business, many companies saw significant drops in profit, which is why they cut their common stock dividends. Many companies cut their dividends more than necessary, using the current economic crisis as justification. They were not sure about the business ramifications of the pandemic and needed to conserve cash.

That doesn’t mean they are bankrupt, but rather they may see significant earnings reductions. Meanwhile, preferred shareholders continue to receive their guaranteed dividends.

If the company filed for bankruptcy, the IRS and bondholders are next in line, followed by holders of preferred stock; ahead of common shareholders.

Are Preferred Stocks Safe?

A few years ago, I concluded the answer was no. My reasoning was, due to the low interest rates, many were priced above face value and could be called in at any time.

Companies have a great incentive to call in preferred shares when they can borrow at extraordinarily low rates. I couldn’t justify paying more than $25.00 face value for a preferred stock, knowing it could be called at any time. I wasn’t willing to take that risk.

I understand why Tim mentioned preferreds in our interview. Due to current economic conditions, many share prices dropped, some well below face value, presenting terrific buying opportunities for savvy investors. Others may be very high risk and investors should not be fooled by their high dividend yields.

This article is part one of a two-part series. Next week I interview Tim. I wrote this first, wanting to use his time educating us on how to find the good ones, and avoid the bad ones.

As George Orwell said in his book 1984, “All animals are equal, but some animals are more equal than others.” The same holds true for preferred stocks.

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