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My Preference

Sanjib Saha, 2:34 am ET

I WAS PLEASANTLY surprised recently when a lump-sum dividend payment showed up in my brokerage account. It was from a preferred stock I bought a few years ago to boost my investment income. The windfall reminded me of the three criteria I’d used to screen preferred shares:

  • Taxation. Unlike bond payments, which are taxed as ordinary income, the income payments from most—but not all—preferred stocks enjoy the favorable tax treatment given to qualified dividends. Since my investments were in a taxable brokerage account, I avoided preferred stocks that didn’t offer this favorable tax treatment.
  • Callable. Preferred stocks typically don’t have a set maturity date, but many of them are callable at the issuer’s discretion. I decided not to pay more than face value for a preferred stock if the call date had already passed or was approaching soon. A few of my preferred stocks have been called away over the years. But since I bought them at a discount, the extra buffer—the difference between the face value and my purchase price—was a consolation.
  • Cumulative. If a bond misses a coupon payment, the creditors can go after the company. Not so with preferred shares. The board of directors can suspend all dividend payments indefinitely to preserve capital. When things look up, and the company can afford dividend payments again, it must resume the preferred stock dividend before that of the common stock.

But what about the missed payments in the intervening period? This is where the cumulative feature comes into play. All unpaid dividends of a cumulative preferred stock must be paid before resuming common stock dividends. I opted to exclude noncumulative preferred stocks from my holdings.

My surprise lump-sum payment was from the cumulative preferred shares of Pacific Gas and Electric, the San Francisco-based utility. The company got into legal and financial trouble, the result of rampant wildfire damage. Facing bankruptcy, it suspended all dividends back in 2017.

Now, for patient investors, the wait was finally over. PG&E resumed dividends last month, coughing up all the unpaid dividends from the past few years.

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Ormode
Ormode
14 days ago

Preferred stocks can be very tricky. You have to understand credit risk, interest rate risk, and call risk. Because the calls are not obligatory, you can end up with a lower-rate security that will trade below par that you are stuck with forever.
Until recently, investors were paying a premium and calculating yield to call, under the assumption that calls were inevitable. Now, many preferreds are well under par.
My recommendation if you are buying now is to buy an issue that is trading just under par. It might get called, but you’re more likely to get your money back if you have to sell. Just be sure to read the prospectus carefully.

Sanjib Saha
Sanjib Saha
14 days ago
Reply to  Ormode

Thanks, Ormode. As you say, buying individual preferred stock needs the same level of diligence, and some more, that’s required for buying individual corporate bonds. I find QuantumOnline to be a good place to start.

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