Most investors are familiar with the major characteristics of common stocks and the benefits associated with them. On the other hand, the ways in which preferred stocks can contribute to a secure financial future are not as widely known. Let’s compare the two types of securities so that you can determine whether preferreds merit a place in your portfolio.
Preferred versus Common Stock Features
Preferred stocks are hybrid instruments with some bond-like and some equity-like characteristics. Like bonds, they rank above common stocks in a company’s capital structure, making them less risky than common stocks. In the extreme case of a corporate bankruptcy, preferred stockholders have priority over common stockholders in recovering at least a portion of their principal.
A preferred stock resembles a bond in that it trades in relation to a par amount. For a preferred, that amount is most frequently $25. Technically speaking, par values exist on common stocks, but they’re nominal figures that have no bearing on whether the prevailing share price is attractive.
Like common stocks, preferred stocks pay dividends rather than—as bonds do—interest. A preferred dividend can be a fixed amount, a variable amount determined by a formula involving a benchmark interest rate, or a fixed amount for an initial period that changes to a variable rate. In contrast, the amount of a common stock dividend is legally at the discretion of the board of directors every quarter. But while the directors can decide to reduce the common dividend, they can also raise it or pay a supplemental special dividend following an exceptionally profitable quarter. Companies that pay common dividends (not all do) generally strive to increase the amount over time.
Dividend Suspensions and Omissions
Unlike a bond coupon, a preferred dividend can be suspended and a common dividend can be reduced or omitted entirely. Dividend suspensions or omissions typically occur when a company’s financial flexibility is compromised or impaired. A preferred dividend suspension or a common dividend omission may proceed without putting the company into default or possibly into bankruptcy. But unlike common stocks’ dividends, many preferred stocks’ dividends are cumulative This means that if any dividends were not paid on schedule, the back money owed to the holders of the cumulative preferreds must be paid before any dividend payments can be resumed on common stock.
As with other provisions discussed below, you cannot automatically assume that the cumulative feature applies to any particular preferred stock. You must check the issue’s prospectus to determine if it contains the provision. For most preferreds, though, the company is barred from suspending the preferred dividend while continuing to pay the common dividend or initiating a common stock buyback. As a practical matter, a company will generally go to great lengths to avoid suspending its preferred dividend, fearing that such action will send the market a highly negative signal about its financial condition.
Dividends on many preferred stocks are taxed at the capital gains rate, rather than the higher ordinary income rate. This advantageous tax treatment is also available for some common stocks, but only preferreds offer corporate holders the advantage of the dividend exclusion provision. It allows corporations to subtract a portion of the dividends received when calculating their taxable income. Most companies’ preferred dividends are paid in quarterly installments, but they may instead be semiannual or monthly. Most common stocks pay quarterly dividends, with a few paying semiannually.
Voting Rights and Maturity Dates
Common stockholders have voting rights, which the majority of preferred shareholders do not. Some preferred stocks, like most bonds, have maturity dates, which common stocks do not. Many preferreds are perpetuals, with no maturity dates, and many of the maturity dates that do exist are several decades in the future.
Whether they are perpetuals or have maturity dates, preferred stocks are generally callable. This means that the company has the option of compelling you to return your shares to the company at par value, or in some cases at a small premium. The usual reason for a company to call a preferred stock is that market-determined rates of interest have declined since it was issued. If that happens, the company can replace its outstanding issue with a new, lower-cost preferred. (The cost to the company is the dividend divided by the preferred share price, plus some underwriting costs. For example, if the annual dividend is $6 per $100 of par value, then for a $25 preferred issued at par the initial yield is $6 ÷ 4 = $1.50, divided by $25 = 6.00%.) As a common stockholder, you may be offered an opportunity to sell your shares back to the company but the company can’t ordinarily force you to accept its offer.
As with common stocks, you can invest in preferred stocks through open-end or closed-end mutual funds, as well as exchange-traded funds, if you prefer that to owning individual securities. Like convertible bonds, some preferreds are convertible into common shares of the issuer. That feature obviously doesn’t apply to common stock.
Contrasting Investment Objectives and Behavior
Preferred stockholders generally emphasize current income and principal preservation. Owners of common stocks are generally more interested in capital appreciation. (Exceptions involve stocks that appeal to income-oriented investors because they pay exceptionally high dividends or are especially noted for consistently raising their dividends)
A yield comparison quickly explains why investors with the two different sets of objectives focus on the asset classes that they do. On December 31, 2022, the median current yield on 26 previously recommended stocks in the Forbes/Fridson Income Securities Investor newsletter was 6.82%. The 12-month dividend yield on the Standard & Poor’s 500 Index of common stocks at that time was just 1.76%. Over the long run, though, total return (current income plus reinvestment income plus appreciation) on an index of common stocks is higher than on a comparable index of preferred stocks.
Consistent with their appeal to investors who are concerned with principal protection, preferred stocks offer some of the defensive virtues associated with bonds. By way of illustration, in 2021 JPMorgan Chase’s common shares fell by 10.6% from their 2021 high, through the end of that year. The bank’s 4.55% perpetual preferred stock, by contrast, experienced only a 2.9% decline from its 2021 high to December 31, 2021. Bear in mind, however, that low volatility is a double-edged sword. JPM common shares soared by 36.7% between their 2021 low and their 2021 high. The 4.55% preferred’s low-to-high gain measured just 7.2%.
Another double-edged sword involves the limited liquidity and relatively infrequent trading of many preferred stocks. The underlying reason is that some of the largest issuers have several different preferred issues outstanding at any given time. As you’d expect, each of those issues has a much smaller dollar amount outstanding than the company’s common stock. Investment managers that have hundreds of billions of dollars of assets under management need to take fairly large positions in any security they own, lest they end up with more names than they can monitor effectively. At the same time, the investment management giants have to avoid owning too big a portion of any security’s total amount outstanding. That could make it difficult to liquidate their position in a name if their opinion on it were to change.
Price Action and Intrinsic Value
Note, however, that the thin trading of many preferreds is not altogether bad for investors who are willing to keep an eye on the price action. A preferred stock’s price can get significantly out of line with its intrinsic value without research-equipped professional traders immediately pouncing on the recognizable bargain. That sort of lag creates opportunities for investors who follow the preferred market closely enough to spot the misevaluations.
You may say that finding misvalued securities is also the premise underlying much—although not all—active equity trading. (Some common stock investors rely instead on technical analysis or market-timing.) That statement is true, but determining intrinsic value is a more subjective process for a common stock than for a preferred stock. If your equity valuation model is Next-Year’s Earnings per Share x Price/Earnings Multiple, you will find that analysts often vary widely in their EPS forecasts for the stock. And assigning an appropriate P/E multiple is more of an art than a science, making it possible for opinions on the subject to differ materially.
Common Stock vs Preferred Stock Intrinsic Value
Determining a preferred stock’s intrinsic value can’t be completely reduced to objective data. But you can narrow down the range of possibilities considerably with certain indisputable pieces of information. These include credit ratings assigned by Moody’s and Standard & Poor’s (although some preferreds are non-rated), dividend rate, call date, call price, and tax rate. This is in no way to diminish the importance of employing rigorous analysis to assess the sustainability of a preferred stock issuer’s current profitability and preferred dividend coverage. But compared with a common stock, there’s less room in valuing a preferred stock for analysts to substitute their personal biases for verifiable facts.
Merger and Acquisition Impact
One last point to be aware of in considering a preferred stock for purchase is merger & acquisition exposure. For common shareholders, a bid to acquire the company is ordinarily good news. The acquirer normally offers shareholders a premium over the previous share price. For the preferred shareholder, the implications may be less favorable. If the acquirer has a lower credit rating than the acquired company, and especially if the acquisition is to be financed with a large amount of new debt, the preferred shares’ ratings may be downgraded. That’s likely to reduce their market value. The transaction may even result in delisting of the preferred shares, further impairing their price.
Holders of preferreds rated below investment-grade (Ba1 or lower by Moody’s, BB+ or lower by S&P), where the issuer’s senior debt rating is also non-investment grade, typically receive some protection against these outcomes through provisions requiring the issuer to redeem the shares in the event that the issuer is acquired. That sort of language isn’t typically found in investment-grade preferreds, but investors can obtain significant protection by focusing on preferreds of regulated companies, i.e., banks, insurance companies, and utilities. These industries account for the vast majority of preferred stock issuance. Their regulators are unlikely to approve M&A transactions that will severely impair the company’s credit quality and put depositors, policyowners, or utility customers at risk.