Today we resume our occasional series on basic investment concepts with an introduction to preferred stocks. These securities have existed since the 19th century but remain a relatively misunderstood asset class. Like any investment, preferreds carry certain risks but can also provide consistent income subject to certain qualifications and the usual caveats relating to understanding the fundamentals.
Until the early 1800s, all shares of a company's stock were equivalent and paid the same dividend. By 1836, railroads were expanding and needed additional capital. Too much debt would magnify risk, but issuing new stock diluted existing shareholders. The solution was a new class of security called a preferred stock, a hybrid that fell in between bonds and common equities.
Preferred shares (also called "preference shares" in Great Britain) paid a consistent dividend that could not be changed, unlike common stocks. In exchange for this regular income stream, preferred shareholders gave up voting rights. The shares rank higher than common stock but lower than bonds in the order of liquidation if the company stubs its toe. And the issuer is prohibited from paying common dividends until the preferred shareholders are paid.
By the middle of the 20th century, preferred share issue became more popular, especially among companies like utilities that needed to raise expansion capital. While preferreds were originally targeted primarily at large institutions, individual investors became increasingly attracted and issuers created a separate class more attuned to smaller portfolios. Texaco issued the first $25 "retail" preferred share in 1993; today the vast majority sport a face or par value of $25. Most of those issues carry distant maturity dates or none at all, and many may be called by the issuer at will beyond a certain specified date.
Throughout the 1990s, banks issued boatloads of "trust preferred" securities. Those amounted to bonds in drag; preferred stock issued by a special trust created to hold the bank's debt. Dodd-Frank regulatory reforms have made these much less attractive to issue and most are gradually being redeemed.
Investors will want to know whether their shares are cumulative, meaning that any missed dividend payments must be made up in full before any common shareholder is paid. Also some preferred stocks are convertible into common shares; that can be voluntary at the investor's discretion, or on occasion mandatory at the option of the issuer. Clearly it is essential to understand the fine print before investing.
Due to their bond-like characteristics, preferred share prices depend little upon the movement of the ordinary shares. Two factors dominate the share price: credit quality and the level of interest rates.
Many retail-oriented preferreds are rated by the primary agencies like S&P and Moody's, much like bonds but somewhat lower due to their junior status. Obviously higher-rated shares command premium prices and therefore lower yields.
Interest rates may exert the largest influence over prices. Since preferreds carry fixed dividend payments, they look a lot like bonds with long maturities. Therefore, if interest rates in the economy are rising, preferred stock prices are likely to fall in response, just as bond prices decline as rates rise.
Investors should therefore be cautious when considering preferred shares for their portfolios. It is tempting to focus on a relatively generous income yield, especially when alternatives like CDs, bonds and cash are lackluster. But beware the potential downside if indeed rates begin to rise over the next couple of years.
Quality preferred shares can be a useful contributor to a balanced portfolio. But don't buy them just for the high income, and understand all the particular conditions of the shares in question.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager at Barnett & Co. in Chattanooga.