What Are Preferred Stocks?

In case you’re not familiar with them, preferred stocks are a sort of hybrid between stocks and bonds. Investors use them as a cash-flow-generating investment since they pay a regular, fixed dividend. In that way they are similar to bonds, which pay a regular, fixed interest payment.

Also like bonds, preferred stocks have a face amount or par value. When and if the issuing entity wants to retire the preferred stocks, they do so by paying the holders of the preferred stocks the face amount.

Unlike bonds, preferred stocks do not have a fixed maturity date. The issuing company may just continue to pay the dividends on the preferred stock for decades. At the option of the issuing company, they may pay off, or call the preferred stock shares at any time after a specified earliest call date, but they are not obligated to do so.

In some ways preferred stocks are like what we normally think of as stocks, which are properly called common stocks. Like common stocks, preferred stocks trade on the major stock exchanges and investors buy and sell them through their regular stockbrokers. Also like common stocks, preferred stocks represent equity in the issuing company, not debt. But unlike common stocks, each share of a preferred stock entitles the investor to a fixed number of dollars of equity, not to a fixed percentage of the company’s total equity. For this reason, preferred shares are not expected to rise in value along with the common shares. Preferred stocks’ market prices do fluctuate, but in a much narrower range than common stocks. Preferred stocks are not investments for growth – they are investments for steady cash flow.

With this background, here are the answers to several recent questions I’ve received on preferred stocks:

Q: Where can I get information on what preferred stocks are available?

A: Several web sites have good information on preferred stocks. At the time of this writing these include the free sites dividendinvestor.com, preferredstockchannel.com, and quantumonline.com. These are not recommendations, just examples, and there are others, so do your research and choose the one that fits your needs best. Neither I nor Online Trading Academy have any affiliation with any of these web sites.

Q: What criteria should I use in considering a preferred stock investment?

A: In my opinion, the reason for considering preferred stocks is as a cash flow generator that is as safe and reliable as possible. If that is not your aim, then consider other investment vehicles. What preferred stocks are not is a day-trading vehicle. This is because, due to thin trading the bid-ask spreads of preferreds can be a relatively large percentage of their value compared to most common stocks. For U.S investors who are looking for safe, reliable cash flow, here are some guidelines for selecting preferred stocks:

• Invest in U.S. preferred stocks. Other countries’ preferred shares have different characteristics.
• They should be traded on one of the major U.S. stock exchanges (NYSE, AMEX or NASDAQ). Those that trade on the pink sheets or OTC tend to have very thin liquidity.
• Invest in traditional preferred stocks as opposed to one of the many other flavors, such as Trust Preferreds, Third Party Trust Preferreds or Convertible Preferreds, which have varying features making them harder to compare.

The above three criteria cut down the total universe of preferred and preferred-like securities from about 1,000 to a little over 400. To narrow those choices further, preferred stocks should have:

• A credit rating that is investment grade. This means that at least one of the three U.S. rating agencies has rated the preferred issue as investment grade, meaning possessing moderate credit risk or better. This criterion narrows the field to about 143 choices
• Dividends that are cumulative. This means that if the issuer does ever suspend payment of the dividends for any reason, they are legally obligated to make them up. This cuts the field down to fewer than 60 candidates.

These criteria are among those that can be specified in quantumonline’s Income Securities Screening Form.

Q: Should I be concerned about day-to-day fluctuations in the prices of preferred stocks?

A: If you see the preferred stock investment as a cash-flow generator, then price fluctuations should not be your primary concern. If the price change is extreme, say a change of 10% or more, you should double-check to see if anything has happened to the issuing company that might indicate financial distress serious enough for them to be unable to continue the preferred dividends.

Q: I have heard that the dividends on some preferred stocks have special tax treatment. Which ones, and how is it different?

A: Dividends on the majority of preferred stocks are qualified dividends, meaning that the dividend income is taxed to you not at your ordinary income tax rate, as interest income would be, but at your long-term capital gains tax rate. Your personal long-term capital gains tax rate is either 0%, 15% or 20%, depending on your income. The exceptions to this special tax treatment are mainly preferred stocks issued by Real Estate Investment Trusts. Their dividends are taxed in the same way as interest income. You should check any individual preferred stock that you are considering to see if it has this special tax treatment. Both quantumonline.com and divideninvestor.com have this information on each preferred stock.

Q: How can I look up preferred stocks on my broker’s trading platform? They don’t seem to match the symbols shown on the web sites.

A: Almost every preferred stock symbol contains a root symbol identifying the issuing company and a series suffix indicating the specific preferred stock series. A single company may issue many different preferred stock series over the years. For example, Public Storage Corp., whose root symbol is PSA, has issued many different series of preferred stock.

The symbology used by various data vendors for preferred stocks varies in the way they present the series suffix. Using as an example PSA’s Series S preferred stock, the symbol for the same preferred stock may variously be shown as:

One of these variations or another will probably match for your broker.

I hope that this information was educational and made preferred stocks more understandable as an investment opportunity.