Once upon a time, preferred stocks were a popular investment with companies and investors. Combining elements of debt and equity, preferred stock was an ideal issue for businesses that lacked the physical assets to collateralize debt or could not attract common stock buyers.
In order to appeal to new investors, companies sweetened the pot by issuing a new security – preferred stock – that had less risk and a greater certainty of income than common stock. If a company falters and requires liquidation, the debt holders are paid in full first, followed by payment to the preferred stock holders in an amount equal to the liquidation value of the preferred stock (established at the time of the initial offering). Common stock shareholders then receive any cash remaining. Preferred shareholders receive full payment of their investment before common shareholders receive any payment. Similarly, preferred shareholders receive dividends before any common stock dividends are paid.
The first preferred stocks were issued by railroad companies and canals in the mid-1800s. Today, preferred stocks are more often issued by entrepreneurial startup companies, organizations in dire financial circumstances that are precluded from traditional debt and equity, or financial companies and utilities. In recent years, preferred stocks have fallen out of favor as investors have turned to common stocks or bonds – but there are a few notable exceptions.
Billionaire investor Warren Buffett is especially active in preferred stocks, usually in combination with attached stock warrants – a legal right to purchase common stock from the company for a defined price. In other words, a share of preferred stock might have a warrant giving the preferred shareholder the right to purchase a share of common stock for a fixed price for a specific term of time. In 2008, Buffett publicly invested $5 billion in a private Goldman Sachs preferred issue with a 10% dividend and warrants to buy $5 billion of stock at $115 per share (43.4 million shares). Other notable preferred stock purchases by Buffett include the holding company that owns H.J.Heinz, Bank of America, General Electric, and Burger King.
Investment grade preferred stocks with current yields between 5.2% and 6.5% have particular appeal to investors seeking high income, especially with current rates from high-quality bonds averaging yields between 1.7% and 3.0%. However, preferred stocks can be complicated, depending upon their composition, and are not for everyone.
Key Features of Preferred Stock
A Hybrid Security
Preferred stocks combine features of equity and debt:
- Equity. They represent an ownership in, rather than a loan to, a corporation. Owners of preferred stocks are given certain preferences – being paid first in full – over common stock shareholders on earnings and assets in the event of liquidation. They also receive dividends before any dividends are paid to common shareholders. In return for their preferred status, preferred shareholders usually give up their right to vote except in limited circumstances in order to protect their status.
- Debt. Price movement of the preferred stock resembles the movement of a debt instrument or bond due to the fixed dividend and redemption at a fixed value. Since most preferred stocks have no maturity dates (or because maturity will not occur until years in the future), they tend to change in price with interest rates as long-term bonds do.
Whether a preferred stock behaves more like a stock or a bond depends upon its contractual features. For example, the price of a preferred stock that can be “converted” into common stock will move in line with the common stock price if the common stock trades at a value higher than the conversion price. Conversely, if the common stock trades at values below the conversion price, the preferred stock (due to the fixed dividend rate) will trade like a bond with price movement based upon interest rate changes.
Additional Features of Preferred Stock
The terms of a preferred stock are defined in a contract between the company and preferred stockholders. The terms may be negotiated privately, as in the case of Mr. Buffett’s investments, or established by stock underwriters immediately prior to the time of public issue.
Most preferred stocks have some combination of the following features:
- Par or No Par. Par value is the stated value of a stock issue – preferred or common – defined in the company charter and is generally unrelated to market value. For example, the company might set a par value of $100 for a preferred share and $1 for a common share, even though the preferred shares trade at $125 and the common stock at $30 per share. Par value is primarily used by accountants to establish “paid-in capital” and “additional paid-in capital” amounts on the balance sheet and regulators to collect registration fees and taxes. No par value means that the company has not set a particular value for a particular stock issue. If there is a par value on a share of preferred stock, the value usually is the redemption price that will be paid when the preferred stock matures and/or the value that determines the conversion details of preferred stock to common stock.
- Convertible or Nonconvertible. Preferred share owners may have the right to convert their preferred shares into common stock on preset terms – allowing them to participate in market increases of the company’s common stock – if a convertible option is attached. For example, shareholders of a preferred stock with a par value of $100 will receive $100 in cash from the company for each share of preferred stock held when the issue expires. If the issue is convertible into 10 shares of common stock, the conversion price is the equivalent of $10 per share per common stock; if convertible into 20 shares, the effective conversion price would be $5 per common share. Generally, the right to convert is limited by the issuer’s right to “call” or redeem the preferred issue at a predetermined price, whether at par or another value set when the preferred stock was issued. Practically, an issuer of convertible preferred shares whose common shares sell above the conversion price (e.g., if the conversion price is $10 and the stock sells for $15) will force conversion of the preferred stock, thereby eliminating an obligation to make regular dividend payments and increasing their common stock equity.
- Callable or Non-callable. Preferred stock may be redeemed or called by the company for payment of the par or other stated value. In some cases, the ability to call or redeem the preferred stock is restricted to a specified period. For example, the company may be restricted from calling the issue during the first two or three years of its life to ensure that purchasers get the benefit of the stated dividend for a certain period or in cases where a convertible option is attached. Potential investors should note that the company can make an offer to redeem in whole or in part the preferred stock at any time allowed by contract, whether or not there is a convertible feature or if the common stock makes conversion more attractive. If there is a convertible feature in the preferred stock, the option to redeem or convert rests with the preferred stock owner.
- Term or Perpetual Life. Like bonds, preferred stocks may have a specific maturity date at which time the company will redeem the stock for cash of a predetermined amount. Some preferred stocks have perpetual lives, like common stock, and can remain outstanding as long as the company is in business. However, since preferred stocks generally react like bonds to interest rate changes, investors should be aware of the time-to-maturity in cases where there is one.
- Fixed or Adjustable Rate of Dividends. The dividend rate of most preferred stock is fixed and established in the certificate of incorporation, but can be variable and change over time. For example, many financial company issuers float the rates of their preferred stock so that the dividend amount varies according to a defined interest rate index. For example, if the dividend is tied to the London Interbank Offered Rate (Libor), the dividend amount is reset each quarter. The variable rate limits price volatility of the underlying preferred stock since the dividend changes in line with the index rate.
- Cumulative or Noncumulative. Since the payment of dividends can be discontinued at any time based upon the covenants associated with the preferred stock at the time of issue and business results, preferred stock dividends are usually cumulative. In simple terms, dividends are not foregone, but deferred. Since no dividends can be paid on common stock until any previously deferred preferred stock dividends have been paid, company management has some pressure to continue or reinstate preferred dividends as quickly as possible. For example, if preferred shareholders are entitled to receive a quarterly dividend of $1 for each preferred share – but business conditions temporarily preclude the use of cash for such purpose – preferred shareholders would have the right to receive $1 per preferred share for each of the quarters where the dividends were omitted at the time that dividends are reinstated. If three quarterly payments are missed, the preferred shareholder would receive $3 per share before common stockholders could receive any dividend; if six dividend payments are missed, the preferred shareholder would receive $6 in dividends before the common stock shareholders received any dividend payments.
- Participating or Nonparticipating. Participating preferred shareholders receive their defined dividend plus extra dividends based on the amount of dividends paid to common shareholders. In other words, the preferred stockholders “participate” equally with common stockholders to share remaining dividends once the common stockholders have received a specific defined rate.
- Voting or Nonvoting. Generally, preferred shareholders do not have the right to vote on corporate matters or elect directors except for those matters that might affect payment of their dividend or preference in liquidation.
- High Dividend Rates. Dividend rates are generally higher than a comparably rated bond since the dividend is not guaranteed like the interest on the bond. For that reason, investors should pay particular attention to the history of dividend payments on any preferred or common stock outstanding. High growth companies generally use their excess cash to fund additional growth rather than pay dividends, while mature companies with less need for cash to fund growth reward their investors with dividends.
- Non-cyclical. Common stock prices generally increase during periods of economic growth and optimistic investor sentiment, and fall during recessions or times of pessimistic investor sentiment. Since preferred stock prices are generally tied to interest rates, they are typically less vulnerable to investor psychology, and are less volatile than common stocks.
- Graded by Rating Agencies. Like bonds, preferred stocks are generally evaluated and rated by the major credit rating agencies (Standard & Poors, Moody’s, and Morningstar), which may provide some degree of confidence in the constancy of dividend payments.
- Qualified Dividends Taxed at Capital Gains Rate. While common stock dividends are taxed as unearned income at normal tax rates, most preferred stock dividends qualify for special tax rates: Tax-free for those in the 10% and 15% tax brackets; taxed at a 15% rate for those in the 25% up to 35% tax brackets; and taxed at a 20% rate for those above the 35% tax bracket. High income taxpayers are subject to an extra 3.8% Medicare surcharge.
Corporations that receive preferred stock dividends can exclude 70% of the dividends from their taxable income.
- Lack of Voting Rights. Preferred stocks, except in unusual circumstances predefined or amended in the certificate of incorporation covenants, do not have a right to vote about the affairs of the corporation, including selection of the board of directors.
- Dividends Can Be Cut or Suspended. Generally, dividends are not guaranteed and can be eliminated by a company’s board of directors at any time, although a cumulative covenant ensures dividends must be paid before any dividends can be paid to common stockholders.
- Limited Upside Potential. Investors receive a fixed (though not guaranteed) dividend rate and may be subject to redemption (call) at the issuer’s option. Since the dividend is fixed, the security behaves as a bond, rather than a stock. As a consequence, preferred shares do not respond to higher corporate earnings (like common shares do) unless there is a conversion feature to common stock.
- Interest Rate Sensitivity. Like bonds, preferred stocks are sensitive to interest changes. If interest rates rise, the market price of preferred stock usually falls.
- Lack of Industry Diversification. Most of the present-day preferred stock issuers are in the banking industry. As a consequence, prices of most preferred stocks are abnormally sensitive to events that affect the financial sector. In order to spread total portfolio risk appropriately, preferred stock buyers should limit their investments accordingly.
Example of Preferred Stock
While the Goldman Sachs issue purchased by Mr. Buffett is not available to the public, the Goldman Sachs Perpetual Floating Rate Noncumulative Series D Preferred Stock (GS-PD) currently trades at around $20 per share with a minimum annual dividend of $1 per share or 4% on the stated $25 liquidation value. The actual dividend rate changes every three months and is set at Libor plus 67 basis points.
On November 15, 2014, the three-month Libor was 0.2321%, calculating the quarterly dividend for the Goldman Sachs Series D Preferred Stock to be $0.226 per share. However, since the rate is below the minimum 4% guaranteed ($0.25 per quarter, $1 per year) the minimum quarterly dividend of $0.25 continues forthwith. Note that this example is for illustration purposes only, and is not a recommendation to purchase.
Preferred Stock ETFs & Mutual Funds
Investors who are interested in receiving higher income, but prefer to avoid the risk of owning a single or small group of preferred stocks might consider one of the preferred stock exchange-traded funds (ETFs), as well as one or more actively managed preferred stock mutual funds. Before making an investment in an ETF or mutual fund, be sure to check past performance and the total costs of acquisition including sales commissions, administration fees, management fees, and trading fees. Generally, preferred stock portfolios are less volatile and less active than other managed funds so that high fees and expenses are not justified. A passively managed preferred stock ETF may provide comparable market performance for less cost.
Examples of preferred stock ETFs and mutual funds include the following:
Preferred Stock ETFs
Actively Managed Funds
As tempting as high returns can be, remember that they also include some risks. Mr. Buffett has the advantage of privately negotiating the terms of his preferred stock because he invests tens of millions of dollars at opportune times. While preferred stocks can increase your annual income considerably, a wise person would put no more than 10% to 20% of his or her fixed-income portfolio into preferred stock instruments.
Preferred stocks are especially suitable for investors seeking high current income, and those willing to accept a higher risk of loss relative to most corporate bonds. Dividend rates are typically higher than interest rates for a similar quality bond, but less secure. In addition, preferred stock dividends are subject to special beneficial tax treatments.
Have you invested in preferred stocks? What was your result?