Preferred Stocks: A Hybrid of Common Stocks and Bonds

High-Yield Investments, Preferred Shares
preferred stocks: Woman looking at stock market data on her computer while holding a newspaper

One thing investors want is high yield. And one thing investors don’t want is to take on extra risk. You may be one of the many investors today who wonder if that’s even possible. 

Before the pandemic, many investors had set their sights on high-yield common stocks to provide enough momentum to generate an attractive income stream for retirement. But the 2020 stock market crash as well as the dividend cuts and suspensions caused many to take a second look at preferred stock.

Preferred stocks, an often unexplored area of the stock market, offer an interesting opportunity for higher yields with less risk.

Buying stock is a popular investing strategy. Essentially, you’re purchasing equity or ownership in an organization. But something you might not even think about is the fact that investors can purchase two different types of stock: common stock and preferred stock.

Preferred stocks, the more obscure option of the two, often boast high dividend yields and dependable income security. For retirees seeking reliable sources of income, preferred stocks can be an appealing option.

Of course, there are a variety of factors to understand and consider as you determine whether investing in preferred stock is right for you. Let’s take a look at preferred shares and see what they’re all about.

What Are Preferred Stocks?

Think of preferred stocks as a hybrid security. Preferred stocks combine features of common stocks and bonds. They are often thought to carry less risk than common stock but more risk than bonds.

Preferred Stocks vs. Common Stocks

Preferred stocks are shares of a company just like common stocks. Unlike common stocks, however, preferred shares typically come with no voting rights. And while common stocks can be bought and held forever, preferred shares are issued with a maturity or a call date. After that call date, the company has the right (but not the obligation) to repurchase or “call” back the shares. 

Volatility is still a consideration for preferred stock holders, but because of the fixed nature of preferred dividends, preferred stock is less volatile than common stock.

Preferred stocks also differ in that they provide some additional protection for shareholders when compared with common stock.

What kind of protection? Good question.

Preferred stockholders have priority over common stockholders when it comes to dividend payouts. They also have priority over common shareholders should an organization be forced into liquidation — meaning the preferred shareholders would be paid before common shareholders. Preferred shares get their name because of this preferential treatment.

While common stock dividends are variable in nature and can be increased, decreased, or eliminated, preferred dividends are fixed. 

Preferred Stock vs. Bonds

You’ll often hear preferred stocks referred to as a hybrid investment because, in many ways, preferred stocks also provide the fixed-income benefits that you might expect from bonds

As previously mentioned, preferred stocks tend to pay fixed dividends on a regular schedule — just like bonds. But preferred stocks pay higher yields when compared with the interest payment you would receive as a bondholder of that same company. 

And like bonds, preferred stocks have a par value, sometimes called face value. So they can be redeemed or repurchased by the issuer for that par value price over a certain period of time.

While bonds have a clearly defined maturity date, preferred stock does not. Unless the company decides to repurchase, or call, the preferred shares, those shares can remain outstanding forever.

Cumulative vs. Non-cumulative Preferred Stock

One more thing to understand about preferred dividends is that they can be postponed or, in some cases, skipped entirely without penalty if a company is unable to make a dividend payment. 

There are two types of preferred stocks: 

  • Cumulative preferred stocks have the right to postpone the preferred dividend, but may not skip it entirely. In this case, the company must pay the dividend at a later date. 
  • Non-cumulative preferred stocks have the right to skip a preferred dividend payout completely, with no legal penalty. 

However, companies are deterred from doing this often since that practice would damage credibility with Wall Street and make it very difficult to raise money in the future.

Most preferred stock is cumulative. This distinction is made in the company’s prospectus and is important to know since cumulative preferred stock helps lower the volatility for investors. 

If a company isn’t able to pay preferred dividends for a certain period of time, that obligation accumulates in the form of back pay for investors. If the company is later able to resume the payment of dividends, no common dividends can be paid until the accumulated dividend back pay is distributed to preferred shareholders.

Why Do Companies Offer Preferred Stocks?

preferred stocks: Magnifying glass and a pen on top of financial statements

Companies issue preferred stocks for a number of reasons. 

First, by issuing preferred stock, the company is able to raise capital without taking on additional debt obligations.  

More debt can mean a lower credit rating, which can then lead to increased borrowing costs for the company. But by issuing preferred stock, the company raises capital and actually lowers its debt-to-capital ratio. This strengthens its balance sheet and cuts borrowing costs at the same time. 

Second, companies choose to offer preferred shares instead of simply issuing more common shares because of the impact on share price. 

You see, when a company issues new common shares, the value to existing shareholders becomes diluted, and the share price typically declines. But because preferred shares trade separately from common shares, preferred stock offerings typically don’t impact the common stock price.

And third, dividend payouts from preferred shares are fixed. To compensate for the fixed nature of the preferred dividend, companies offer a higher yield. But over time, the company’s dividend expense doesn’t increase, which means more money in the company’s pocket at the end of the day. 

How To Find and Choose Preferred Stock

Understanding the company offering the preferred stock is important. Take a look at financial institutions, for example.

Because of increased regulations in the industry since the 2008 financial crisis, these companies must demonstrate adequate capital reserves and limit riskier trading activities. Such regulations help preferred shareholders, since this kind of stability means steadier dividend payments.

It’s also important to understand the criteria for choosing preferred stock. When you narrow down a list of companies offering preferred shares, take a look at the first call date as well. Preferred stocks cannot be called for a predetermined number of years. So current dividends are secure until that first call date. 

So, where should you look for preferred stocks? Knowing that preferred dividends will always be paid first, a good place to begin looking is among companies that are repurchasing shares or raising common stock dividends.

U.S. banks are also a good place to find solid preferred stocks — largely because of those increased regulations imposed after the 2008 financial crisis we mentioned earlier. You’re going to find more substantial capital reserves and fewer risky trading practices. 

Mutual funds and exchange-traded funds (ETFs) are available if you’d like to avoid selecting preferred stock companies on your own. Such instruments enable you to invest in hundreds of preferred stocks. 

Use Preferred Stock To Generate Income for Your Retirement

Group of smiling seniors enjoying a meal

Preferred stocks offer an interesting investment opportunity to achieve higher dividend yields with less risk than common stocks. These higher yields can provide dependable income security for retirement. 

Because after all, what does everyone want and need? Cash flow.

To learn how to generate the kind of cash flow that can lay the groundwork for retirement, subscribe to the Investors Alley “Dividend Hunter” newsletter.

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