Information about preferred securities is not as readily available as is information about a company's common stock. For that reason it pays to do a little more research, to understand how they are similar to bonds, and how they differ.
Typically issued by banks, real estate investment trusts, and utilities, preferred stocks usually pay a fixed rate of dividends. That makes them similar to bonds, which usually pay a set dollar amount of interest. Payments are usually quarterly, better than for bonds, which typically pay just twice a year. Issuers of preferred securities give preference over holders of common stock when paying out the dividends.
Before any company issuing them reduces dividends, it must first ax those paid on common stock. Any such decision of course can affect the company's credit rating. Consequently most companies issuing these securities rarely reduce the dividend paid on preferred classes of their shares.
Preferred holders also get preference over common holders in the event a company liquidates or goes bankrupt. Of course bondholders get first dibs on the firm's assets, in this scenario; preferred shareholders would be paid from assets left over.
So, if these stocks are harder to understand, why consider them? There are several reasons why investors should give these a closer look. One: preferred stocks generally yield more than a company's common stock and sometimes yield more than the firm's bonds. In addition, dividends from some preferred stocks are qualified, meaning that they are taxed at a top federal tax rate of 23.8%*. Non-qualified dividends are taxed at a maximum federal rate of 43.4%*. For this reason, it's best to use non-qualified preferreds inside of tax-deferred accounts, such as IRAs.
Two: in the context of current market volatility, preferred stocks can be less risky. That is, they oscillate less in value day to day than do common stocks. Of course, bonds - that is, actual bonds, not the mutual fund or ETF forms- can move around even less as they are not as actively traded by retail investors. Therefore, they usually don't exhibit the wild swings that the equities market may on a particularly volatile day.
This said, when compared to common stocks, preferred stocks offer less opportunity for appreciation. Like bonds, they tend to trade within a narrow range near their par or face values and are purchased primarily for income, not growth.
However, rising interest rates can reprice preferred stocks downward below their par values, raising the current yields for new buyers. Existing shareholders would be holding discounted valuations until redemption. For this reason, inflation and rising interest rates are risk factors. Because preferreds pay fixed dividends, higher rates could force down preferred share prices.
Unlike bonds, preferred shares do not have a fixed maturity date, but most may be redeemed by their issuers. Before buying a preferred, find out when it can be called and at what price. You could lose principal if the stock is redeemed at a call price below your purchase price.
Have questions? Time for a checkup. Review the level of fixed income in your portfolio and whether you are adequately diversified for yield and return.
*Includes Medicare Investment Income Tax of 3.8%