When building portfolio goals, one of the most important questions to ask yourself is what assets are part of your portfolio, and why do you hold them? Many DIY investors understand common asset classes like equities (stocks) and bonds, but their understanding may lead them to overlook an important and profitable asset class… preferred stocks.
Strictly speaking, preferred stocks are a part of the equities asset class because they are issued by companies and are not a debt product. However, preferred stocks combine some of the best qualities of equities and bonds which could make them a valuable part of your portfolio.
If you’re looking to increase your asset class diversification, and grow your portfolio income these are the things you should know about preferred stocks.
What are preferred stocks?
Preferred stocks are a class of ownership with a fixed dividend yield. Typically preferred stock holders do not have voting rights in the company. In the event of a company liquidation, preferred stockholders are the first stockholders with a claim to assets that remain after creditors are paid off. As an asset class, preferred stocks act like a hybrid of bonds and stocks.
Companies issue preferred stock for a variety of reasons, but it is most frequently issued in lieu of a debt product (a bond), or to limit the voting rights of stockholders during critical change periods.
How are preferred stocks like bonds?
Much like bonds (and other debt products), preferred stocks provide a predictable stream of income. The dividend yields are not guaranteed like debt products (like corporate bonds), but they have a greater provisions than the dividends from common stock. For example, most preferred stocks have a set dividend yield, and if the dividends aren’t paid, “dividends in arrears” must be paid to preferred stock owners before dividends can be issued to common stock holders.
Issuers of preferred stock often have the right to “call” a preferred stock which means buying back the stock at face value after a certain number of years; this property means that prices on preferred stock are more stable (showing little upside potential, nor much downward risk). In a falling interest rate environment, buy-backs are common, but in a rising interest rate environment, most companies will not call their preferred stock.
Generally speaking, preferred stock holders do not have voting rights in a company which is also true of bondholders (but not true of common stock holders).
How are preferred stocks like stock?
Failing to pay the dividends is not quite the same as failing to service a loan (as is the case when a bond is issued), so the yields on preferred stock tend to be higher than those on bonds from the same company. A company that does not pay its preferred stockholder dividend is not considered in default, but it does indicate that the company is in trouble.
Like common stocks, preferred stocks do not typically have a maturity date. This means that the guaranteed dividend payment will persist in perpetuity. Preferred stocks can maintain or grow in value over time (typically the value does not grow as rapidly as common stock).
Why consider preferred stocks for your portfolio?
Preferred stocks offer a great way to stabilize income and value in your portfolio. A long term investment in preferred stocks can yield higher income than bonds and higher value in the event that a company liquidates than common stock.
Although preferred stocks have risks (such as lower growth potential, and less value in the event of bankruptcy than bonds), they constitute a healthy place in many portfolios. Preferred shares can be purchased individually or through ETFs and Mutual Funds.
As you review your asset allocation, consider the role that a high income choice like preferred stocks might play in your portfolio especially compared to common stocks or company held bonds.
|Common Stock||Preferred Stock||Bonds|
|Reliable Income Potential||Lower||Higher||Highest|
|Preference in liquidation||Lowest||Mid||Highest|