10.1: Preferred Stock

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Preferred stocks are stocks that have a prior claim ahead of common stocks on the income and assets of the issuing firm. They are one type of Hybrid Security. They are sometimes called Fixed-income Stocks because they usually pay a fixed dividend. The dividend is usually a percentage of a preset par value of the preferred stock in much the same way as a bond pays a fixed interest amount on the par value of the bond. However, preferred stocks represent equity and therefore, do not count as debt on the corporate balance sheet. And like common stocks, there is no maturity date as there is with a bond. There is also no guarantee of continued dividends; a corporation can suspend preferred stock dividends at any time. In case of corporate default, preferred stocks have priority over common stockholders but are subordinate to bonds. They are truly a hybrid mixture of both stocks and bonds.

When people hear the term preferred stock, they often believe that preferred stock is a better choice than common stock. It is true that preferred stock typically pay a reliable stream of dividend income and have priority over common stock investors in case of default. The critical issue, however, is that preferred stock typically does not participate in the success of the corporation, whereas common stock does participate in the success. For this reason, some professionals refer to preferred stock as bonds even though, legally, they are not bonds. The interest payments on bonds are mandatory; the dividend payments from preferred stock are not mandatory.

The Advantages and Disadvantages of Preferred Stocks

Preferred stocks typically offer a highly predictable stream of dividend income and, as a whole, have an excellent record of meeting those dividend payments. A major benefit of preferred stock is the tax benefits that are offered to corporations who own the preferred stock of another corporation. Corporations that receive dividends on preferred stock can deduct 50% to 65% of the dividend income from their corporate taxes. This strong incentive to corporations turns out to be a strong disincentive to individual retail investors like us. Because of this provision, corporations are willing to pay a higher price for preferred stocks than would be prudent for individual investors. This is the major reason that although the name preferred stocks is attractive to individual investors, the actual investment vehicle is not.

What are the disadvantages? Preferred stocks are susceptible to inflation risk, similar to bonds. Like common stocks, dividends can be suspended or postponed, unlike bonds, which must pay interest or risk default. Like bonds, because of the fixed nature of the dividends, there is a lack of potential of substantial capital gains, unlike common stock. Last, preferred stocks normally do not pay as well as bonds but the yield has been very close to bonds over time. And of course, the dividends of the common stocks of many corporations have grown substantially over the years whereas preferred stock dividends remain fixed.

We see that preferred stocks have some of the advantages of both stocks and bonds and some of the disadvantages of both stocks and bonds. They offer the best and the worst of both worlds. Also, the universe of preferred stocks is much smaller than either stocks or bonds. For these reasons, many in the industry recommend stocks for growth and income and they recommend bonds for income.

The Yield and Pricing of Preferred Stock

The dividend yield of preferred stock is annual dividend income divided by the preferred stock price, similar to the current yield of a bond or a common stock.

                  Annual Dividend Income
Dividend Yield = ──────────────────────── 
                   Current Market Price

For example, if the annual dividend income for a preferred stock were $2 and the current market price were $27.50, then the dividend yield would be:

                    $2
Dividend Yield = ──────── = 0.0727272727 or 7.27%
                  $27.50

This preferred stock is yielding 7.27% annually.

As with bonds, preferred stock prices fluctuate mostly inversely to interest rates. However, with preferred stock, there is a greater risk of non-payment of dividends. Recall that the dividends for both common stock and preferred stock are not mandatory. Bonds, on the other hand, would be declared to be in default if the interest is not paid. The bond issuer would be hauled off to bankruptcy court.

The pricing formula for preferred stock is:

          Annual Dividend Income
Price = ─────────────────────────── 
         Prevailing Interest Rates

Does this formula look familiar? It’s the Zero Growth Model. Well, of course, it is. Preferred stock dividends don’t grow! For example, if the annual dividend income were $2.50 and currently, prevailing interest rates are paying 12%, then the formula would become:

         $2.50
Price = ──────── = 20.833333 or $20.83
          0.12

We would predict the market price of this preferred stock to be approximately $20.83.

Some Characteristics of Preferred Stock

Some preferred stocks have a conversion feature. They are referred to as Convertible Preferred or just Convertibles. This allows the holder of a preferred stock to convert to a specified number of shares of the issuing company’s common stock. This helps alleviate one of the major disadvantages of preferred stock. With a conversion feature, if the corporation is very successful, the investor can then share in the growth of the common stock. We will discuss convertible securities in more detail in the next section.

A few preferred stocks are Adjustable-rate Preferred Stocks. They are often referred to as Floating-rate Preferred or just Floaters. Instead of being fixed, the dividends are adjusted periodically in line with prevailing interest rates. They are often tied to Treasury rates or other indexes. This helps alleviate the inflation / purchasing power risk.

Some companies issue different classes of preferred stock called Senior Preferred, Preference Stock, or Prior Preferred. Similar to the senior and junior bonds, the most senior preferred stocks are guaranteed to be paid before the less senior (aka junior preferred), etc. Also similar to bonds, preferred stocks can be issued as callable preferred or non-callable preferred. If interest rates fall, the issuer would want to refinance the preferred stock at a lower dividend rate similar to how a bond issuer would want to refinance their bonds at a lower interest rate. Finally, some preferred stock is issued as Participating Preferred Stock. This is a rare form of preferred stock that allows investors to participate in the earnings of a corporation beyond the stated dividend rate, similar to how many companies will increase the dividends of their common stock as their earnings grow.

Cumulative versus Non-cumulative Preferred Stock

One of the most sought after types of preferred stock is Cumulative Preferred Stock. Remember that with both preferred stock and common stock, the dividend payments are optional. Both can be suspended at any time. However, with cumulative preferred stock, if the company suspends the preferred stock dividends, those foregone dividends are said to be “in arrears.” The “in arrears” dividends must be paid before any future dividends can be paid, whether for preferred or common stock. Hence, cumulative preferred stock is preferable to non-cumulative preferred stock. And as expected, cumulative preferred stock will be able to offer a lower dividend to investors than non-cumulative preferred stock because of this provision.

What is the bottom line on preferred stock? Preferred stock is normally owned by corporations. Some individual investors may acquire a taste for them but it is our opinion you are better off with common stock for growth and income and bonds for income.