Preferred Stocks: Performance, Volatility And Risk-Adjusted Returns

Public market investors generally invest in two types of securities: common stocks and bonds.

Common stocks represent ownership in the underlying company, accompanied by voting rights for issues of corporate importance. Bonds are debt instruments with a fixed coupon payment and predetermined maturity date. Companies issue bonds when they need to raise capital but do not wish to dilute their existing common stockholders.

Common stockholders have the most potential upside if a company performs well, but also the most downside if a company goes bankrupt.

Common stockholders receive liquidation payments in banktrupcy proceedings after bondholders do, which is one reason why stocks are viewed as more risky than bonds.

Most investors do not explore the third major type of financial instrument: preferred stocks. These securities are somewhere between common stocks and bonds and have characteristics similar to each in different ways.

Preferred shares have the potential for price appreciation (similar to common stock), but also have fixed dividend payments (similar to bond coupon payments). Preferred shares also have a higher claim on assets and earnings than common shares.

This article will provide a brief introduction to preferred stocks and compare their historical performance to domestic stocks, domestic bonds, and international stocks on both a nominal and risk-adjusted basis.

About Preferred Stocks

Preferred stocks are called ‘preferred‘ because of their seniority compared to common stocks when it comes to being paid back during a bankruptcy.

An investor will ideally not have to experience owning a company that declares bankruptcy. Fortunately, there are other benefits to owning preferred stocks.

Since preferred stocks are considered lower risk (and lower return) than common stocks, one would expect that they have lower volatility – and this tends to hold true in practice. By the same logic, preferred shares should (and do) have higher volatility than bonds.

Accordingly, preferred stocks can be used to lower the volatility of an equity investment portfolio. Preferred shares can also be perpetual, which means that they will be around as long as the company is. For fixed income investors, this presents an advantage over bonds because bonds have a fixed maturity date.

There are also downsides to preferred shares. For dividend growth investors, the main disadvantage to investing in preferred shares is that they have a fixed dividend payment. This downside is counteracted by the yield and safety of a preferred share dividend. Preferred stocks generally pay higher dividends than their common stock cousins. Further, a company in sound financial condition is highly unlikely to cut the dividend on its preferred share – which makes them a strong source of current portfolio income.

Investors looking for growing dividend income would be better off investing in the common stock of companies with proven histories of increasing their dividend payments. A fantastic group of such companies is the Dividend Aristocrats – companies with 25+ years of consecutive dividend increases.

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