Preferred Stock

PREFERRED SHARES have a devoted following among a segment of investors, who are attracted by the relatively generous yields, often 5% and above. Despite their name, preferred shares are more like bonds than regular (or “common”) stock. Forget price appreciation. Over the long haul, almost all of your return will likely come from a preferred’s regular dividend payments.

Preferred shares might climb in price if interest rates decline. But unlike common stock, preferred shares don’t benefit from rising corporate earnings. Those higher earnings may make the preferred’s dividend more secure, but they won’t result in the dividend being increased, because that is typically fixed.

Preferreds usually have a 30-year maturity, though they can often be called after five years. Keep that in mind when analyzing an individual issue. For instance, a preferred might have a high current yield, which is simply the annual dividend payment divided by today’s share price. But the issue might be callable at a price that’s below the current trading price. If the company retires the issue before the maturity date, current buyers would suffer a price loss. This potential loss is reflected in the yield-to-call, which will be below the current yield.

If a company files for bankruptcy, preferred shareholders only receive money after bondholders are paid off. Does that mean preferreds are risky? That’s rather like asking, are bonds safe? There’s a big difference between Treasurys and junk bonds. Similarly, preferreds come in all kinds of flavors—and the best guide to risk is probably the yield. If you see an unusually high yield, it could mean the company’s finances are shaky.

If you own preferreds in a regular taxable account, some will qualify for the federal government’s special dividend tax rate, which is 20% or less, while others are taxed at the income tax rate, which can be as high as 37%. Want to keep things simple? Instead of purchasing individual issues, check out exchange-traded index funds such as iShares Preferred and Income Securities ETF and SPDR Wells Fargo Preferred Stock ETF.

Next: Junk Bonds

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Articles: My Preference and Not Preferred

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