Including preferred stocks in a portfolio along with common stocks and bonds is a popular way to diversify risk. At times when interest rates on bonds are low, dividend yields on preferred stocks become attractive alternatives. Preferred securities don’t fit neatly into either the stock or bond category. If a corporation were to file bankruptcy or liquidation, bond holders would have top priority in terms of getting paid, owners of common stock would be taken care of last, and preferred security owners would be in the middle spot. Preferred stock dividends must be paid prior to paying common stockholders. On a company’s balance sheet, a preferred security may be classified as either debt or equity. Either way, preferred stock tends to add “ballast” to the “ship” when seas are rough.
Because of their secondary position in the capital structure, preferreds have a higher risk level as compared with bonds. At the same time, they have a perceived lower capital appreciation potential than common stock. As a result, preferreds typically offer investors a higher level of income than either their bond or common stock counterparts.
One benefit of preferred securities is that most pay qualified dividend income. Like the dividends on common stock, preferred dividends are taxed at capital gains rates, comparing favorably to bond interest, which is subject to ordinary income tax rates.
Ironically, while preferreds have been used for portfolio diversification, industry diversification within the preferred stock universe itself has been quite low. As of the end of last year, close to half of all preferred securities were issued by banks, with another 20% issued by insurance companies. The remaining quarter was spread among industrials, utilities, and Real Estate Investment Trusts (REITs).
Despite the low industry diversification within the preferred stock category, there is ample opportunity for diversification by security type. Preferred stock categories include:
Adjustable rate preferreds
Dividends vary with a benchmark such as the T-bill rate. Because of this flexibility, the prices of adjustable rate preferreds are often more stable than those of fixed-rate preferred stocks.
The issuer has the right to redeem the stock at a present price after a defined date.
Holders have the option to convert the preferred shares into a fixed number of common shares any time after a predetermined date.
This type of stock stipulates that any skipped or omitted dividends must be paid to its holders before common shareholders can receive dividends.
These securities offer a fixed dividend for five or ten years, after which the dividend will typically adjusts based on a benchmark such as the 3-month LIBOR (London Interbank Offered Rate).
Only the current year’s dividend needs to be paid in order for a corporation to pay a dividend to its common stockholders.
These take precedence over common stock in the event of a liquidation.
Trust preferred stock
The company creates a trust, issues debt to the trust, which then issues preferred shares to investors. Trust-preferred shares are generally issued by bank holding companies.
Preferred stock investors are looking for securities that have the potential to deliver steady and consistent income while at the same time preserving capital; they use preferreds as a tool to diversify their common stock and fixed income portfolios. And with so many different structures available, it is possible to achieve portfolio diversification not only with, but within, the preferred securities marketplace. Visit Sheaff Brock money management to learn more about investing with preferred stocks.