Imagine that a stock and bond got married … their baby might be preferred stock.
What Are Preferred Stocks?
The preferred stock hybrid shares characteristics with bonds and stocks. As the name suggests, preferred gives the shareholder a place in line ahead of common stock holders, whenever a company pays dividends or distributes assets to shareholders. And, should the company go bankrupt, if you own preferred shares, you’re more likely to recoup losses than a common shareholder.
Yet, preferred stock isn’t uniform and varies from company to company. In some firms, preferred shareholders must receive dividends ahead of common stockholders. In other cases, should dividend payments be missed, preferred shareholders get all of their dividend payments before the common shareholders receive anything.
Yet, preferred stock and preferred stock ETFs have advantages and disadvantages.
Unlike bond investing, preferred stock might not have a defined lifetime, unless the shares get called or repurchased. So, while an individual bond has a maturity date, most preferred stock doesn’t.
Preferred stock might offer more stable cash flow than common stock. Beyond that, there are countless varieties of preferred stock, all with their own distinctions.
So, when considering investment risk, the hierarchy is as follows: stocks, preferred stocks and then bonds.
Finally, a preferred share may contain an obligatory or optional clause or call provision that enables the company to buy back the shares at a predetermined price clause or to convert the preferred shares to common stock.
If this sounds a bit confusing, you’ll find the details for each company’s preferred shares in the prospectus.
For easier investing, buy a preferred stock ETF and forgo the research as the share-picking falls to the fund issuer.
Why You Might Consider Adding a Preferred ETF to Your Portfolio
Other preferred stock benefits typically include higher yields than the company’s stock and debt. And, for tax purposes, most preferred stock dividends are considered qualified dividends and taxed at a lower rate than bonds’ non-qualified dividends.
Investors seeking broader diversification might also consider preferred stock. And an investing app can make it easy and cheap to invest in a preferred ETF.
Preferred stocks should hold their value better than existing bonds that are expected to decline in value as interest rates increase. And their share prices are likely to be less volatile than their common stock counterparts.
Risks of Investing in Preferred Stocks
With rising interest rates, bond values decline. This isn’t too much of a problem if you own individual bonds and hold them until maturity, when your principal is returned.
With longer-term bond funds, you can expect the value of your investment to decline, even as your dividend payments rise.
Preferred stock prices might also fall, as interest rates rise, yet, typically the preferred shares won’t drop in value as much as a comparable bond with an increase in interest rates.
Individual preferred stocks could be subject to default risk, although this is less likely due to their position between stocks and bonds on the bankruptcy payment ladder.
Where to Invest in Preferred Stocks
Rick Ferri, CFA and founder of Core-4® Investing considers preferred index funds such as the iShares U.S. Preferred Stock ETF (NASDAQ:PFF) and the Global X US Preferred ETF (BATS:PFFD) low cost ways to access this hybrid investment category. With 296 holdings, PFF is diversified and follows the S&P Preferred Stock Index as a benchmark. This fund has a 5.74% yield and a 0.47% expense ratio.
Invesco Preferred ETF (NYSEARCA:PGX) is another large fund with a 5.82% yield and a 0.50% expense ratio. With an effective duration of 5.42 years, you can expect limited price volatility in this high-yielding fund. Eighty percent of PGX must be invested in U.S. dollar-denominated preferred securities, issued in the United States and be rated at least B3. The PGX benchmark is ICE BofAML Core Plus Fixed Rate Preferred Securities Index.
The Bottom Line
Like any investment, preferred stock investing must fit in with your goals and timeline. If you’re seeking a bit more yield than a bond, with less risk than a stock, then now might be a good time to invest in a preferred stock or fund.
As of this writing, Barbara Friedberg did not hold a position in any of the aforementioned securities.