The Risks, Rewards, and Who Should Own Preferred Stocks

In last week’s video, we gave you a quick introduction to preferred stocks and how they’re different from common stocks.  If you missed it, watch it here.

The next issue has to do with the risks and potential rewards of owning preferred securities, along with the big question: how do you know if they’re suitable for YOU?

Preferred stocks are really designed to provide a steady income through dividend payments, and their yields tend to be higher than traditional fixed income investments.  For some people, this really adds to their appeal.  Most of them are traded on a stock exchange, so you may also see greater transparency with the price.

Some preferred stocks are what they call “convertible,” meaning that under certain conditions, you can exchange them for shares of common stock.  This could be a good thing because the preferred stockholder can benefit if there’s a rise in the common stock’s price.

On the other hand, many preferred stocks are also “callable.”  What this means is that the company can “call” the stock away from you, the stockholder, and force you to sell the stock after a certain date at a predetermined price.  This could present a risk to you, because if interest rates go down, making their fixed dividend worth more, the preferred stock probably won’t go up in value much because of the threat of being called away.

There are some that pay “cumulative dividends,” which means that if a dividend payment is ever missed, it has to be paid eventually, as long as the company has the ability to do so before a dividend on the common stock is paid.  Those dividend payments are not guaranteed, though.

One thing you need to consider is that many preferred stocks are perpetual in nature – in other words, unlike individual bonds, they have no maturity date which will tell you when your investment will be returned to you.  If interest rates fall, that may not be an issue, but if they go up, the dividend will be worth less and the preferred stock’s price may fall. This is what’s known as interest rate risk.

As for taxes, not all income from preferred securities is taxed the same way.  Different issues from the same company might be structured differently and have different tax consequences, so make sure you understand what those might be.

But if you’re looking for a potentially higher payout than what you might get on bonds and dividends from common stocks, and a security that puts you ahead of common stockholders in the capital stack, preferred stocks may be something you should consider adding to your portfolio.  Just make sure you understand that the higher yields mean there’s greater risk than bonds.  If you want more information on how a preferred security may fit into your overall plan, just give us a call here at Lucia Capital Group and we’ll help you out.