What's Preferred about Preferred Stocks

Question:  I am a big fan of your columns on personal finance.  As a retiree I really need dividends and bond interest to supplement my income.  As we all know, bond interest is scarce, especially for government and high-grade corporate bonds. Preferred stocks pay a higher rate of return than most of these and seem to be well regarded but I don't hear much about them.  Some of our major corporations issue them and I wonder what are the pros and cons of using them as a portion of my portfolio.  I would appreciate any insight you have on this under-covered asset. 

Answer:  At first glance, preferred stocks can look very attractive. They represent capital stock issued by a corporation, giving preferred stockholders the appearance of ownership. They pay higher dividends then common stocks, and their dividends have priority over “common” dividends.  Some preferred stocks have effective yields over 6%, and some preferred stocks pay dividends that qualify under IRS rules for the special maximum 23.8% federal income tax rate on qualified dividends and capital gains. Some preferred stocks are “convertible,” meaning that the owner can take real ownership in the company by swapping preferred shares for common shares. 

But with preferred stocks, not everything may be as rosy as it seems. They are complicated and come in several varieties and share classes. To begin with, you won’t find it as easy to learn about individual issues of preferred stocks as you will common stocks.  You may have trouble finding information about them in the newspaper and even on the internet. I don’t recommend that you buy individual preferred stocks unless you are well versed in corporate finance and have lots of time to do research. While common stockholders have voting rights, preferred stockholders do not except in certain instances.  Preferred dividends have priority over common dividends, but the issuing company must pay bond interest before they pay preferred stock dividends and the company can suspend payment of preferred stock dividends if they fall upon hard financial times.  Suspended dividends, in most cases, will accumulate and eventually be paid. This means that if you buy a preferred stock for quarterly dividend income, that regular income stream is not guaranteed. Some preferred stock issues are callable, meaning that if market interest rates go down, the issuing company is likely to call the stock and refinance at a lower rate, leaving you - the investor – out in the cold.  

Although I don’t recommend that you buy individual preferred stocks, you could consider a mutual fund or an exchange traded fund that holds many preferred stocks.  By owning a fund, you don’t have to bother trying to select stocks yourself, you can enjoy the advantages of preferred stocks while handing off the responsibility of choosing and managing them to a fund manager, and you diversify away individual company risk. Exchange-traded funds that attempt to track the price and yield performance (before expenses) of the S&P U.S. Preferred Stock Index are good choices.  Stay away from closed-end mutual funds that use leverage.  They may have higher yields, but the downside risk isn’t worth it. 

 

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to ken@montereypw.com.