Should investors consider 'Preferred Stocks' in current environment?| The Rational Investor

Robert Stepleman
Robert Stepleman

In a rising interest rate environment, many fixed-income investments need careful vetting before purchasing. One of those investments is “Preferred Stocks.” As we shall see, in the current economic reality they may not actually be “preferred” and perhaps should even be avoided by many investors.

Their main attraction is a high yield when compared to CDs or money market funds. Recently, at the Preferred Stock Channel, the average yield of preferred stocks they cover was 7.4%. This compares to about 4.5% for five-year CDs. This extra return comes with extra risk of loss of principal or suspension of dividends. Preferred stocks also pay substantially higher dividends than the S&P 500’s recent 1.8%.

Let’s review what they are.

Preferred stocks are hybrid securities. They are like common stocks because they pay dividends instead of interest and provide the holder with company ownership. They are like bonds because the dividends of most preferred stocks are fixed. Additionally, if the company enters bankruptcy, the preferred stockholder gets paid before the common stockholder. They also receive their dividends before the common stockholder. The preferred stocks of Real Estate Investment Trusts have a further advantage. Since their common stocks must pay dividends if the company has taxable income, it’s unlikely that a REIT preferred wouldn’t pay its dividend.

Some preferred stocks are “convertible.” This means they can be exchanged for common stock. This is good because the preferred stockholder can benefit from a rise in the common stock’s price. Many preferred stocks are “callable.” This means the company can force the preferred stockholder to sell the stock after a specified date at a predetermined price. This is bad because if interest rates fall, making their fixed dividend worth more, the preferred stock is unlikely to rise in price due to the call possibility. Some pay “cumulative” dividends. This means if a dividend is skipped, it must eventually be paid. Some preferred stocks adjust their dividends periodically based on some index; for example, the 90-day U.S. Treasury bill rate. This provides protection against interest rate increases.

Like bonds, preferred stocks are rated by Standard & Poor’s. Many are below investment grade; that is, rated lower than BBB-. However, if bonds of the same company are investment grade, it’s not critical.

Perhaps most critical, is unlike bonds, many preferred stocks are “perpetual;” that is, they have no maturity date when an investor knows her shares will be redeemed. This means if interest rates rise as they are now, the fixed dividend will be worth less, and the preferred stock’s price may fall, never to return.

The “ideal” preferred stock is investment grade, has a cumulative dividend higher than alternatives like “junk bonds” or is indexed to interest rates, has several years of call protection and sells below its call price. In the current rising interest-rate environment, investors should carefully balance the likely higher dividends of fixed-rate preferred stocks versus the potential for higher future dividends from an indexed preferred.

Investors considering a preferred stock should use quantumonline.com to understand it. There are also mutual funds and ETFs that specialize in these.

All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at rsstepl@tampabay.rr.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.

This article originally appeared on Sarasota Herald-Tribune: ROBERT STEPLEMAN: 'Preferred Stocks' lose appeal as interest rates rise