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Richard Groh, CFP (800) 495-2075 (California)
Certified Financial Planner, Richard Groh, explains how PREFERRED STOCKS act more like bonds than stocks and may be a good choice FOR INVESTORS SEEKING INCOME.
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PREFERRED STOCK can earn income for your portfolio. When interest rates are low, their yields can pay better than other fixed-income investments.
WHAT'S THE DOWNSIDE?
If interest rates rise, preferred stock prices can decline. Given the right income objectives and risk tolerance, preferred stocks can help diversify a portfolio—if you understand how they work.
A STOCK DRESSED AS A BOND
Preferred stocks pay fixed dividends, which makes them act like bonds in the marketplace. They are more sensitive to interest rates than to the fortunes of the issuing company. Yield is calculated the usual way, by dividing the annual dividend by the price of the stock, and is a fixed rate at the time of purchase. Dividends are generally paid quarterly.
MATURITY
Preferred stocks differ significantly from bonds since they lack a maturity date (not to be confused with call date, discussed below). With no maturity, investors can never be assured that they will receive their principal back on a specified date in the future. They can always sell their stock, of course, but they have no assurance that the stock will trade at or near their purchase price.
TAXES
Preferreds have long been popular investments for corporations because of the dividends-received deduction, which allows corporations to exclude from taxable income 70% of the dividends received from preferred stocks. Until the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2004, individual investors always paid ordinary income tax on preferred dividends (unless they were in tax-favored accounts, of course). Now the dividends may be taxed at the new lower rate of 15% (or 5% for investors in the 10% and 15% tax brackets) as long as the stock meets certain requirements.
QUESTIONS TO ASK BEFORE INVESTING:
ARE DIVIDENDS CUMULATIVE?
If the company gets into trouble and can't pay the dividend, will the missing dividends accrue and eventually be paid out to shareholders (cumulative), or will the company simply resume paying dividends whenever it can (noncumulative)? Most preferred stocks are cumulative, which means any dividends in arrears must be made up and paid to preferred shareholders before dividends can be restored to common shareholders. Other things being equal, cumulative preferred stocks should carry a higher value (and lower yield) than noncumulative preferreds.
IS THE PREFERRED CALLABLE?
Most preferreds can be redeemed (called) by the company after a stated date. Call features benefit the company, not the investor, because they allow the company to assess the interest rate environment and retire the issue when rates are low—precisely when investors do not want to receive a wad of cash to reinvest. This is why preferred stocks that are freely callable (that is, whose call date has already passed) tend to be priced lower (i.e., carry higher yields) than issues that cannot be called for a period of time.
ANY SPECIAL PROVISIONS?
A typical sinking fund preferred might require the firm to retire half the issue over a 10-year period by retiring, say, 5% of the issue each year. Such sinking fund preferreds actually have implied maturity dates, but unfortunately, investors have no way of knowing whether their shares will be called.
IS THE PREFERRED CONVERTIBLE?
Convertible preferred stock may be converted into a certain number of shares of common stock. The conversion features—the ratio, price, and period—are stipulated in the prospectus. Depending on where the common stock is trading, the convertible preferred may trade more like a bond or more like a stock. For example, if the price of the common is depressed so that its trading price is well below the conversion price, the convertible will lose its tie to the underlying common stock and begin to trade like a bond. The issue should then trade according to prevailing bond yields. Conversely, when the common stock trades well above the conversion price, the preferred will more closely track the common price.
CREDIT RISK?
Will the company keep paying the dividend? For the answer, look to the standard rating agencies, Standard & Poor's and Moody's, or Duff & Phelps or Fitch. As with bonds, credit risk is factored into the price of preferreds. The higher the rating, the lower the yield, and vice versa. For conservative clients, stick with investment grade—BBB or better—and be alert to the possibility of ratings changes.
SUMMARY
Preferred stocks are more difficult to evaluate than other types of securities because of the number of factors to consider: yield, credit risk, conversion features, call features, and taxation of dividends. All of these features must be evaluated in conjunction with one another in determining which issues would best meet a client's objectives. But that's also the beauty of preferreds: you can find issues to meet a variety of investment objectives, from preservation of capital and modest yield to capital appreciation and even speculation.
FOR MORE INFORMATION
Call Certified Financial Planner, Richard Groh, (800) 495-2075
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