Income investors seeking high yields from dividend stocks are often curious about and attracted to preferred stocks. Preferred stocks are considered a hybrid security because they combine features of common stocks and bonds. They typically carry less risk than common stock but more risk than bonds.
The main attraction for preferred stocks is their above-average yields. But in times of stock market uncertainty, there is also the potential for significant capital gains. For retirees seeking reliable sources of income, preferred stocks can be an appealing option.
As you would with any investment consideration, there are a variety of factors to understand as you begin looking for the best preferred stocks. We’ll review what preferred stocks are, what to look for in a preferred stock, and how to get started investing in them.
What Are Preferred Stocks?
The term “preferred” is indicative of the fact that these shares have “preference” over common stock dividends when it comes to dividend payments. In other words, a company must pay its preferred shareholders before its common stockholders.
What to Look for in a Preferred Stock
It is possible to earn safe, stable, and high yields from preferred stocks.
You want to keep several considerations in mind when looking for the best preferred stocks. These considerations include coupon rate, call date, and stock market uncertainty.
Preferred stocks pay a fixed dividend based on a coupon rate and a par value.
Coupon rate is the yield paid by any fixed income security. And par value for a preferred stock is the amount upon which the dividend is calculated.
In most cases, the par value is $25. So you’ll multiply par value by coupon rate and divide by four quarters. So a preferred stock with a 6% coupon rate will pay a $0.375 per share preferred dividend every quarter.
As of March 2021, the largest preferred stock fund, the iShares Preferred and Income Securities ETF (NASDAQ:PFF), has a current yield of less than 6%. You’ll want to set your sights on earning more.
The bottom line?
- Look for a coupon rate of 7% or better.
Preferred stocks are issued with a period of time, usually years, before they can be called back by the issuing organization. The date when the issuer has the right to call back the shares is called the call date. A common call date is five years after the IPO. Dividend income is secure and protected until the call date.
Then, at the time of the call date, the preferred shares can be called at par value and the interest rate at that time often adjusts so fixed dividends become floating rates. Both of these events are undesirable.
The bottom line?
- Look for a call date that is at least three years away. Seek high-yield preferred stocks that will not be called away, and therefore subject to loss, for at least three years.
Companies can issue preferred stocks at any price, but most often, preferreds are priced at IPO at $25 per share.
But during market downturns, preferred stocks can be exchanged at far lower prices. When the market normalizes and preferreds return to the average $25 per share range, there is a sizable opportunity to enjoy capital gains appreciation as well as the higher dividend yields typically seen with preferreds.
If, for example, you bought a preferred stock right now for $10 per share, you’d be delighted if the issuer called it at $25 at some point in the future.
Of course, with upside potential comes risk — like if the organization issuing the preferred stock experiences a cash flow shortage and is unable to pay the dividends. This risk could present a simple dividend delay for investors holding cumulative preferred stocks, since the issuer is obligated to pay missed dividends at a later time unless they file for bankruptcy.
But the risk could mean a skipped dividend for investors holding non-cumulative preferred shares, since the issuer is not obligated to pay missed dividends to those shareholders at a later time.
After the 2008 financial crisis, U.S. banks are now held to a higher standard when it comes to maintaining capital reserves and risk mitigation practices, making them a good place to find solid preferred stocks.
Because preferred dividends will always be paid first, educated investors will find companies who are sending signals of strong cash liquidity. These companies are repurchasing shares or raising common stock dividends.
The bottom line?
- Play it safe, and seek out preferred stock issuers who have sufficient cash reserves on hand to pay out dividends.
- Acquire shares for less than the $25 par value. Most preferred shares are callable at par, so it wouldn’t feel great to pay $27 for some preferred shares only to have them called away at $25.
Should I Buy Individual Preferred Stocks, ETFs, or Mutual Funds?
Whether you invest in individual preferred stocks or in shares of exchange-traded funds (ETFs) or mutual funds, there are pros and cons to each option.
Individual Preferred Stock
Just like you would buy a common stock, you can use your brokerage account to buy individual shares of a preferred common stock.
The pros here include:
- Visibility: You’ll know exactly what you’re getting. You can see important terms like yield, call date, credit quality, etc.
- Control: Since this is a much more hands-on investing approach, you have the opportunity to control whether you sell and when. This kind of control can help minimize your taxable dividend income.
- Extra work: You’ll have to conduct your own due diligence. It’s important to understand the company offering the preferred stock.
- Extra risk exposure: When it comes to diversification, you’re on your own. You’ll need a solid understanding of the rest of your retirement portfolio. Diversification is important so you don’t place too much risk of income or capital loss on yourself. After all, any handful of businesses can become financially distressed or go into bankruptcy at any time.
Preferred Stock ETF or Mutual Fund
Purchasing shares of an ETF or mutual fund that is dedicated to preferred securities is another option. Of course, fund investing for common and preferred stocks benefit the investor because of shared expenses, economies of scale, operational efficiency, and simplification of the investing process.
The pros that are more specific to preferred stockholders within this option include:
- Diversification: Because professional money managers are at the helm of these investment vehicles, you’re more likely to successfully minimize your risk exposure. This is thanks to effective diversification.
- Simplification: Even if your ETF or mutual fund is significantly concentrated on a specific sector, investment professionals know what to look for when it comes to dividend payment history, interest rate environment, risk tolerance, etc.
- Infinite duration risk: When preferred shares inside of a fund are called, the fund reinvests them into other preferred shares with different prices and different yields. In turn, you face increased interest rate risk and share price volatility.
- Variable income: As the fund’s overall mix of preferred stocks changes over time, the payouts you can expect will also change and become increasingly variable.
Get Started Finding the Best Preferred Stocks
As you can see from the many pieces of the preferred stock puzzle we’ve covered today, navigating a complicated asset class like preferred securities is no easy task. You’ve got several choices to make and plenty of research to do.
Now that you know more about preferred stocks and what to look for, subscribe to Investors Alley’s “Dividend Hunter” newsletter for top stock picks and investing tips.