Preferred stock is a hybrid investment combining certain elements of both equity and debt securities. Preferred stock ranks just below unsecured debt and just above common stock in a company’s capital structure. Preferreds usually carry a dividend like common stock, but an advantage for the preferred stock holder is that the payment of dividends has preference over common stock dividends. This preference, of course, does not insure that the payment will be made, but the company must pay it before paying any common stock dividend.
Preferred stocks generally pay yields that are higher than bond market yields, common stock yields (dividends) and money market yields, but have little or no price appreciation potential and are much less liquid than common stock.
Preferred stock dividends may be cumulative or non-cumulative. Cumulative preferred stocks provide that any dividend payments missed or deferred by the issuer accumulate until paid in full while non-cumulative preferred stocks provide that any dividend payment missed is gone forever. Originally most preferred stock was cumulative but, in recent years, many companies have started issuing non-cumulative preferreds.
The owner of preferred stock generally has no voting right in the company but has priority over common stock owners if the company should be liquidated. In addition, certain preferred stocks may be convertible into common stock.
Preferreds are like bonds in that they are rated by the major rating agencies. Generally, preferred stocks have lower ratings than bonds of the same issuer because preferred dividends do not have the same guarantees as interest payments from bonds. Preferred stock also has a lower rating than bonds because they are junior to all creditors.
In short, preferreds are senior to common stock, but are subordinate to bonds and unsecured debt.
Preferred stocks rose to prominence in the early 1990s. By 2005, the preferred stock market had quadrupled in size to $193 billion, before shrinking back to $100 billion in 2008 because of concerns regarding default and conversion risk.
In recent years, many preferred stocks have been issued by companies that have already loaded their balance sheets with debt and need to raise capital without risking a credit rating downgrade. Under such circumstances, an investor is facing considerable risk.
The main selling point that brokerage firms use in the sale of preferreds is their high yield relative to other like investments. Yields on preferred stock are generally higher than that of corporate bonds, money market and common stock. Of course there is risk associated with receiving the higher yield; it’s called default.
Because of their position in the corporate structure, brokerage firms like to emphasis the seeming safety of preferred stock, particularly as compared to common stock. Of course, brokerage firms sometimes forget to mention to preferred stockholders that if the issuer has serious financial problems, preferred stockholders can end up in the poor house right beside the common stockholders.
Brokerage firms also fail to adequately disclose that unlike a corporate bond that has a set maturity, preferreds generally have either no maturity or a very long maturity. Therefore, you could wind up owning a preferred for a long time. As Larry E. Swedore and Jared Kizer state in their book The Only Guide to Alternative Investments You’ll Ever Need.
The historical evidence on the risk and rewards of fixed-income investing demonstrates that longer maturities have the poorest risk-reward characteristics – the lowest return for a given level of risk (with risk being defined as volatility, or standard deviation.)
Another often over-looked provision of preferred stock is the call feature. If the underlying company is doing well, it will call in your preferred shares, thus depriving you of your high yield.
Almost all the return to be made from preferred stocks comes from the dividend payments. This means that if investors are looking for growth and appreciation, they should look elsewhere.
If you have investment losses or problems involving preferred stocks, call the lawyers at Page Perry for experienced representation at (404) 567-4400 or (877) 673-0047 (toll free).