What Is Preferred Stock? | Is It Right for My Portfolio?

What Is Preferred Stock? | Is It Right for My Portfolio?

Investing in the stock market can be a confusing endeavor, with a wide variety of options available to investors. One type of investment that often gets overlooked is preferred stock. While common stock is more well-known, preferred stock offers different advantages and disadvantages that may be appealing to certain investors. In this article, we will explore what preferred stock is, how it differs from common stock, and whether it may be a suitable addition to your investment portfolio.

Understanding Preferred Stock

Preferred stock, also known as preferred shares or simply “preferreds,” is a class of ownership in a corporation that has a higher claim on the company’s assets and earnings than common stock. Unlike common stockholders, preferred stockholders do not typically have voting rights at shareholder meetings. However, they have a higher priority claim on the company’s assets and earnings, making them “preferred” over common shareholders in the event of bankruptcy or liquidation.

Preferred shares usually pay a fixed dividend, which is typically higher than the dividends paid to common shareholders. These dividends are often paid out before any dividends are distributed to common shareholders, making preferred stock resemble a hybrid between stocks and bonds. Preferred stocks are often seen as less risky than common stocks due to their steady dividend payments and priority in the event of financial distress.

Differences between Preferred Stock and Common Stock

While preferred stock and common stock may seem similar, there are several key differences that investors should be aware of:

1.

Dividends:

Preferred stockholders have a fixed dividend rate, which is agreed upon at the time of issuance. This fixed dividend is usually paid out quarterly or semi-annually and is generally higher than the dividends paid to common shareholders. In contrast, common stock dividends are not fixed and can fluctuate based on the company’s performance and board decisions.

2.

Voting Rights:

Preferred stockholders typically do not have voting rights in the company. Common stockholders, on the other hand, usually have the right to vote on important company matters, such as electing the board of directors or approving mergers and acquisitions.

3.

Asset and Earnings Priority:

In the event of bankruptcy or liquidation, preferred stockholders have a higher claim on the company’s assets and earnings compared to common stockholders. This means that preferred stockholders are more likely to receive their investment back before common stockholders receive any proceeds.

4.

Capital appreciation:

Common stockholders have the potential for capital appreciation if the company’s stock price increases. Preferred stockholders, however, generally do not benefit from significant capital appreciation. Their returns primarily come from the fixed dividend payments.

5.

Risk:

While preferred stock is considered less risky than common stock due to its fixed dividend payments and higher claim on assets, it still carries some level of risk. If the company faces financial difficulties, preferred stockholders may face a reduction or elimination of their dividend payments.

Is Preferred Stock Right for Your Portfolio?

As with any investment, the suitability of preferred stock for your portfolio depends on your individual financial goals, risk tolerance, and investment strategy. Here are a few factors to consider when deciding whether preferred stock is right for you:

1.

Income:

If you are seeking a consistent income stream, preferred stock may be a suitable choice. The fixed dividend payments provide a predictable cash flow, making it attractive for income-focused investors.

2.

Stability:

Preferred stock is often seen as a more stable investment compared to common stock. If you prefer a lower-risk investment with a higher claim on assets and earnings, preferred stock may align with your risk tolerance.

3.

Diversification:

Including preferred stock in your portfolio can diversify your investment holdings. By adding a different class of shares, you can spread your risk across various types of securities.

4.

Time Horizon:

Consider your investment time horizon before incorporating preferred stock into your portfolio. If you have a longer time horizon, the stability and dividends offered by preferred stock can be beneficial. However, if you have a shorter time horizon and seek capital appreciation, common stock may be more appropriate.

5.

Investment Goals:

Assess your investment goals and the role preferred stock may play in achieving them. If your primary objective is income generation, preferred stock can be an attractive addition. However, if you prioritize capital growth, you may want to focus on common stocks instead.

Ultimately, the decision to include preferred stock in your portfolio should be based on a thorough evaluation of your individual circumstances and investment objectives.

Frequently Asked Questions (FAQs)

1. What is the difference between preferred stock and bonds?

Preferred stock and bonds share some similarities, such as fixed payments, but also have significant differences. While preferred stockholders have an ownership stake in the company, bondholders are creditors who lend money to the company. Preferred stockholders have a higher claim on the company’s assets and earnings compared to bondholders in case of bankruptcy or liquidation.

2. Can preferred stock be converted into common stock?

Some preferred stocks offer conversion features that allow stockholders to convert their shares into a predetermined number of common shares. This conversion option provides investors with the potential for capital appreciation if the company’s common stock price increases.

3. Are preferred stock dividends guaranteed?

Preferred stock dividends are typically considered less risky than common stock dividends, but they are not guaranteed. If a company faces financial challenges, it may suspend or reduce its dividend payments to preferred stockholders.

4. Are preferred stock dividends taxable?

Yes, preferred stock dividends are generally taxable. The tax treatment of preferred stock dividends is similar to common stock dividends and depends on the investor’s individual tax situation. It is advisable to consult a tax advisor for specific guidance.

5. What are the different types of preferred stock?

Preferred stock can have various features and characteristics. Some common types include cumulative preferred stock (accumulated unpaid dividends carry forward), non-cumulative preferred stock (unpaid dividends do not accumulate), participating preferred stock (entitled to additional dividends beyond the fixed rate), and convertible preferred stock (can be converted into common shares).

6. How is preferred stock valued?

Preferred stock valuation considers factors such as dividend yield, interest rates, credit risk, company financials, and market demand. Professional investors use financial models to determine the fair value of preferred stock based on these factors.

7. Can I lose money by investing in preferred stock?

Investing in preferred stock carries some risk. If the issuing company faces financial difficulties or defaults on its obligations, preferred stockholders may experience a decline in the value of their investment or a suspension of dividend payments. However, the level of risk depends on the individual company and market conditions.

8. How can I buy preferred stock?

Preferred stock can be purchased through brokerage accounts or online investment platforms. Investors can evaluate available offerings and select preferred stocks that align with their investment objectives and risk tolerance.

9. Are preferred stock dividends higher than interest rates on bonds?

Preferred stock dividends are typically higher than the interest rates on bonds. However, the exact levels vary depending on market conditions, company stability, and the specific terms of the preferred stock issuance.

10. Can preferred stock lose value when interest rates rise?

Preferred stock prices can be influenced by changes in interest rates. When interest rates rise, the value of existing preferred stocks in the market may decline as investors seek higher yields elsewhere. However, individual company performance and overall market conditions also play significant roles in the stock’s value.

11. How do credit ratings affect preferred stock?

Credit ratings assess the creditworthiness of companies, including those issuing preferred stock. Higher credit ratings indicate lower risk, potentially resulting in lower interest rates offered on preferred stock and increased investor confidence. Conversely, lower credit ratings may lead to higher yield requirements to attract investors.

12. Can I sell preferred stock before its maturity?

Preferred stock does not have a fixed maturity date like bonds. It is generally traded on stock exchanges and can be sold by investors at any time, subject to market liquidity.

13. Can preferred stock be called?

Some preferred stocks have a call provision that enables the issuing company to redeem or repurchase the shares after a specific period. This typically occurs at a predetermined price set at the time of issuance. Investors should carefully review the terms and conditions of the preferred stock to understand potential call risks.

14. Who typically invests in preferred stock?

Preferred stock can be attractive to income-focused investors, conservative investors seeking stability, or institutional investors looking for steady dividend payments. However, individual investor preferences vary widely, and the suitability of preferred stock depends on one’s specific investment goals and risk tolerance.

15. Should I consult a financial advisor before investing in preferred stock?

If you are uncertain about investing in preferred stock or any other financial instrument, consulting a financial advisor is highly recommended. A professional advisor can help assess your financial goals, risk tolerance, and overall investment strategy to determine if preferred stock aligns with your portfolio.