Should You Prefer Preferreds?
by Charles B. Carlson, CFA
Dow Theory Forecasts

Anemic interest rates on many fixed-income investments, such as treasury securities and certificates of deposit, have caused investors to look elsewhere for income. One area that has received lots of attention is preferred stock. However, before you consider putting preferreds in your portfolio, it's important to understand what perferreds are and, more importantly, what they are not.

Preferred stock is issued by companies to raise funds, similar to the issuing of equity and debt. Preferreds typically pay a fixed dividend rate each quarter. Unlike common stock, preferred stock usually has no voting rights. However, preferred stock has superior rights to common stock in the case of bankruptcy or liquidation.

Preferred stock is often viewed as a hybrid investment of sorts, a cross between common stock and bonds. In reality, however, preferred stock is somewhat of a misnomer. Preferreds behave much more like a bond than a stock and should be viewed that way by investors.

For example, the two greatest factors affecting the price movement of preferred stock are interest rates and the company's financial position. These are also the two biggest factors affecting the pricing of a company's debt. Also, because of the fixed nature of the dividend (unlike the dividend of the common stock, which can fluctuate from year to year), preferred stock offers little hedge against inflation. This is also the case with corporate bonds, in which the coupon payment is fixed from year to year.

Another characteristic preferred stock shares with bonds is that both generally have "call" features. In other words, most preferred stock may be repurchased by the company anytime after the callable date.

Of course, the question that matters is the following: Are preferreds a good deal for individual investors? Keep in mind that corporations that own preferred stock receive a tax break on the dividend income generated by the preferred. This tax break, however, is not available to individual investors. Thus, you could argue that, because of the corporate tax break, the yield on preferred securities is artificially low for individuals.

Bottom line: In most cases, an investor is probably better off owning the company's bonds rather than the preferred. Why? Because the bonds will likely pay a higher interest rate, are redeemed at par at maturity (unlike preferred stock, which has no predetermined maturity date), and have a higher ranking in the pecking order than preferred when it comes to liquidation and bankruptcy.

Despite the shortcomings of preferred stock, there may be instances when these securities make sense in a portfolio. One advantage is liquidity. Since preferreds trade on stock exchanges, it usually is easier to buy and sell them relative to bonds.

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