The last decade has been challenging for fixed income investors, as the yields offered by all types of issuers have dwindled amid persistently high demand for safe, income-generating securities. Preferred shares are one pocket of the fixed income market where investors can still typically find reasonable yields without taking on undue risk. In part because the preferred market is much smaller than the equity and bond markets—about 1% and 3% of each, by market cap—preferred stock yields have remained relatively higher than the yields on other types of corporate debt.
Despite its name, preferred stock doesn’t represent or confer ownership—it’s debt, like a bond or loan. Also like bonds, preferreds have fixed distribution rates. So you’d only buy a preferred for steady income, not capital gains.
That said, preferred stock can generate a very steady income. The yields are usually between 4% and 8%. And preferred shareholders are usually better protected—both in and out of bankruptcy—than common stock holders.
Most preferred stock is issued at a par value of $25, with a fixed coupon rate. The coupon rate times the par value determines the annual distribution, which won’t change over time. But the preferred’s yield may vary above or below the coupon rate, depending on whether the preferred is trading above or below par.
Most preferreds issued at $25 will trade in a range between $23 and $27, depending on market conditions and investor sentiment about the company and the preferreds. If a preferred is trading above par, investors think the yield is attractive enough to pay a premium to the security’s face value. If it’s trading significantly below par, investors may have concerns about the company’s creditworthiness.
But generally, preferred stock dividends are very safe because they are paid before dividends on the common stock. And preferreds are above the common stock in the capital structure, so in bankruptcy, preferred shareholders’ claims on the company’s assets are superior to ordinary stockholders’ (although in practice, both usually get nothing).
Preferred stock dividends are also usually cumulative, meaning that if the company doesn’t pay some (or all) of its promised distributions, investors will receive them at a later date. The unpaid portion is considered “dividends in arrears” and must be paid before any other dividends.
Most preferreds are also callable. Callable preferreds will have a call price (usually also $25) and a call date. On or after the call date, the company has the right to buy back the preferreds from investors for the call price. Call dates are usually set five years after the issue date.
Preferred shares will typically be called if the company can save money by issuing new debt at a lower interest rate, just like refinancing your mortgage at a lower rate. An interest rate that is even half a percent lower is enough to entice most companies to refinance. Typically, companies can issue new debt at about the same yield as their existing preferreds trade.
But the company has no obligation to call its preferreds, and many preferreds are not called for years after their call dates.
If your preferreds are called, you’ll receive the call price of the shares plus any unpaid dividends. Having your preferred called can be a good thing if you bought it below the call price, and a bad thing if you paid too much for it.
If you’re considering buying a preferred above its call value but aren’t sure if it’s a good idea, you can use a calculator to check your yield to call. For example, let’s say you’re considering paying $26 per share for a preferred that pays $2 a year in dividends but is callable at $25 in two years. If the preferred is called, you’ll lose $1 per share. But you’ll earn $4 in dividends in the meantime. Thus, your yield to call (average annual return until the call date) would be 5.82%, quite a bit lower than the current yield of 7.69% (= $2/$26) but still decent. You can figure out your yield to call using a calculator like the one at https://www.preferred-stock.com/calculator_ytc.php.
Some preferreds also have maturity dates, which is a date between 30 and 100 years after the issue date when the preferreds must be called. Preferreds that don’t have maturity dates are called perpetual.
And some preferred stock is convertible, meaning it can be converted into ordinary stock on or after a given date. This option gives preferred stockholders more potential upside, although convertible preferreds will often trade at a premium as a result.
One downside to preferred stock is that preferred holders usually don’t have voting rights as common stockholders do.
In addition, preferred ticker symbols are not standardized—they usually take the form of the issuing company’s stock symbol followed by a letter indicating the preferred series, but some also include dashes, dots or a ‘P’ for preferred—so always double check to make sure you’re buying the specific issue you want.
Lastly, while preferred stock is theoretically as easy to buy and sell as common stock, most preferred stocks are very lightly traded. Use limit orders when buying so you don’t pay more than you want to, and avoid preferred stocks trading less than 4,000 shares daily, on average.
You may also want to buy an ETF that holds preferred shares instead of individual issues, as we’ve done in the Safe Income Tier of the Cabot Dividend Investor portfolio.
The iShares U.S. Preferred Stock ETF (PFF), PowerShares Preferred Portfolio (PGX) and SPDR Wells Fargo Preferred Stock ETF (PSK) ETFs all have low expense ratios, good yields, diversification and adequate volume. The largest and most popular of the funds is the iShares offering, PFF. However, PFF’s holdings have the lowest overall credit quality of the three funds. The PowerShares and SPDR offerings limit themselves to investment-grade preferreds to minimize credit risk. Though any of the three are a fine source of regular income, in our portfolio, we opted to go with the PowerShares ETF because it pays dividends monthly.
We don’t currently hold any individual preferred shares in our portfolio, but investors looking to add individual preferreds to their portfolio can start by looking for preferreds issued by companies they already own. Currently, only two of the companies in our portfolio have outstanding preferreds. Welltower (HCN) has one outstanding convertible preferred, but because the stock is currently trading above the conversion price of $59, the preferred trades more or less in-line with the stock.
The other company is BB&T Corp (BBT), which is unsurprising since preferreds issued by financials make up at least 85% of the market.
BB&T has five classes of outstanding preferred stock, all perpetual, callable and with coupon rates between 5% and 6%. The series D, E and F preferreds are already past their call dates, but have not been called, while the G and H shares are callable in 2018 and 2021, respectively. While BBT-H has the longest time remaining until its call date, the shares are currently trading above par value, around $27, so they offer a yield to call of only 3.12%. The D, E and F shares are all trading slightly above $25. All the shares pay distributions on the first of March, June, September and December, and the distributions are eligible for the 15% tax rate.
If you’re interested in adding individual preferreds to your portfolio, you’ll find a wealth of information about individual preferred stocks at quantumonline.com, including annual distributions, call and maturity dates, whether they’re cumulative or convertible, and whether their dividends qualify for the 15% dividend tax rate.