What you need to know about preferred stock

In many ways, listed companies are the ultimate democratization of wealth. Both the Sultan of Brunei and plumbers near you can buy any number of shares they want, such as Cisco Systems, Inc. (CSCO). The only barrier to entry is the few dollars spent on creating E*Trade Financial Corp.. (ETFC) account.

Sometimes a company wants to attract a certain type of investor; the kind that wants fixed, scheduled payments. In order to do this, companies can issue bonds, but these bonds have their own shortcomings. When a company authorizes the issuance of bonds, it may be announcing that it urgently needs cash, which may scare off stock investors. How to guarantee investors a certain amount of regular payment while issuing equity? Through the magic of preferred stocks, preferred stocks are a bit like a mixture of bonds and common stocks. (For more information, see: Getting started with preferred stocks.)

The difference between preferred stock and common stock is small, but crucial. Preferred shareholders do receive dividend payments: dividends are a selling feature and are inherent to securities. For common stocks, the company is not obliged to provide dividends. (For more information, see: What is the difference between preferred stock and common stock?)

Become rare

In fact, blue chip companies that provide dividends on common stock do not issue preferred stock at all. Companies that do not provide dividends on common stocks rarely do so. Preferred stock is a dying stock. It is estimated that for every dollar of preferred stock, $80 of common stock is circulating in the United States. Apple Inc. (AAPL), Exxon Mobil Corporation (XOM), Microsoft Corporation (MSFT) and other heavyweight companies have not provided preferred shares. Among the 30 largest companies in the US by market capitalization, the only ones offering preferred shares are the four major banks-Wells Fargo (WFC), Bank of America (BAC), Citigroup (C) and JPMorgan Chase & Co. (JPM). In fact, approximately 88% of preferred shares are issued by banks. As for the reason, it is the aftermath of the financial crisis and the continuation of the corresponding rescue plan in 2008-09. Preferred shares become an additional asset on the balance sheet, and banks need this asset more than oil companies and semiconductor manufacturers. (For more information, see: Features of preferred shares.)

No voting rights

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Most things in life involve trade-offs, and preferred stock is one of them. From an investor’s point of view, one of the main disadvantages of preferred stocks is that their holders have no voting rights. From the name alone, you would think that preferred shareholders will receive preferential treatment. However, when a company elects members of the board of directors, it is the ordinary shareholders who conduct the election, while the preferred shareholders sit on the sidelines and are deprived of the right to vote. (For more information, see: Know your rights as a shareholder.)

Better during bankruptcy

On the other hand, suppose the listed company goes bankrupt. When the company is liquidated, bondholders are paid first. This makes sense; they are creditors, and they lend money to companies to help them make ends meet. Once the bondholders are all done, if there are any remaining, preferred shareholders will get paid next. Only in this way can ordinary shareholders get paid, if any. Therefore, the “first choice” among preferred stocks.

There are also some other differences between preferred stock and common stock. The latter can be called by the company at its sole discretion. “We reserve the right to repurchase these stocks from you on May 17, 2016.” In most cases, you can convert preferred stocks into common stocks at a predetermined rate. In doing so, you sacrifice volatility and the possibility of capital appreciation.

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Okay, enough theory. Suppose you want to buy preferred stock. Assuming you did open a brokerage account like the plumber in our example, how would you start?

Looking for preferred stock

First, how to read preferred stock listings. They are different from common stock lists, which are easy to read. International Business Machines Corporation (IBM) common stock (the only stock offered by the company) is listed on the stock symbol under the three-letter code IBM. Boom, give me a hard one.

Preference shares are more complicated. Since dividend payment is very important, preferred stock is defined by its dividend (expressed as a percentage):

Symbol

name

Price 10/11/14

SSW-E

Seaspan Corp. (SSW) 8.25% accumulation

24.95 USD

SCE-B

Southern California Edison 4.08%

21.04 USD

SCE-C

Southern California Edison 4.24%

USD 21.25

SCE-D

Southern California Edison 4.32%

22.80 USD

ZB-A

Zions Bancorp (ZION) floating interest rate (min 4%)

24.60 USD

It’s simple, isn’t it? The stock code includes a letter suffix to indicate that the stock is the first choice. The 26 letters of the Roman alphabet is a good thing, because a company can issue various types of preferred stock, which is why we include three different Southern California Edison preferred stocks in our example.

Treat like a bond

It is no coincidence that the prices for all issues are roughly the same. With very few exceptions, preferred shares are listed at a price of $25. They are not much different from that price, which tells you that the market treats them almost like bonds. No one will bid more than $25 to buy redeemable stock, and no one will sell such a valuable income-generating asset for less than $25. By the way, the issue price is also the price at which the company chooses to issue shares. (For more information, see: Why do some preferred stocks have higher yields than common stocks?)

Understandably, the higher the dividend rate, the more expensive the stock. Buying a 4.08% stake in Southern California Edison, you will receive a quarterly dividend of 25.5 cents. The number of dividends is expressed as a percentage of the issue price (also $25).

A few more points. “Cumulative”, such as Seaspan 8.25% cumulative preferred stock, means that if the company has not paid a specific dividend in the past, the dividend will be accumulated until it is paid. It will be paid before ordinary shareholders receive any dividends. In Seaspan’s case, the company did pay its common shareholders a quarterly dividend (if unstable), and it has been so for many years. “Floating interest rate” means that the dividend payment changes according to the standard determined by the issuer. In the case of Zion Bancorporation, the interest rate is linked to the London Interbank Offered Rate. (For more information, see: Preferred stock valuation.)

Bottom line

Among intermediate and high-level securities, preferred stocks have a relatively small learning curve and low risk opportunities. Compared with ordinary shares, preference shares are less likely to go bankrupt. So should you invest in them? Understand that most preferred shareholders are institutional: investing funds into institutions that are more volatile than bonds or bond equivalents will result in small gains and large losses. For everyday investors, buying preferred stock is usually after you have established a portfolio of the right size. One possibility, at least in part, is the result of buying undervalued common stock. However, if you are still interested, please consider preferred stock exchange-traded funds (ETFs). (For more information, see: Preferred stock ETFs with good dividends.)

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