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How to Play Preferreds
12/18/2017 5:00 am EST
Preferred shares are one pocket of the fixed income market where investors can still typically find reasonable yields without taking on undue risk, explains income expert Chloe Lutts Jensen, editor of Cabot Dividend Investor.
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.
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.
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) exchange-traded funds 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.
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