Preferred Stock Investing
Enhance portfolio income and reduce volatility with these hybrid securities that combine features of stocks and bonds
Strategy Type
Income Generation
Risk Level
Moderate
Time Horizon
Medium to Long-Term
Ideal For
Income-Focused Investors
What Are Preferred Stocks?
Preferred stocks are hybrid securities that combine features of both stocks and bonds. They represent ownership in a company (like common stocks) but typically pay fixed dividends at regular intervals (like bonds). Preferred stockholders have priority over common stockholders for dividend payments and asset claims in case of liquidation, but they usually don't have voting rights.
These securities are called "preferred" because they have preference over common shares in two critical areas: dividend payments and claims on assets. Companies must pay dividends to preferred shareholders before distributing any dividends to common shareholders, and in the event of bankruptcy, preferred shareholders have claims on assets before common shareholders (though after bondholders).
Key Benefits
- Higher Yield: Preferred stocks typically offer higher dividend yields than common stocks and many corporate bonds.
- Lower Volatility: Price fluctuations are generally less severe than common stocks, providing more stability.
- Payment Priority: Preferred dividends must be paid before common stock dividends, providing greater income security.
- Tax Advantages: Many preferred stock dividends qualify for lower dividend tax rates, unlike bond interest.
- Diversification: Adds a distinct asset class to portfolios, with return patterns that differ from both stocks and bonds.
Preferred Stocks vs. Common Stocks vs. Bonds
To understand preferred stocks' unique position in the investment landscape, it's helpful to compare them with common stocks and bonds:
| Feature | Common Stocks | Preferred Stocks | Corporate Bonds |
|---|---|---|---|
| Payment Priority | Last priority | Higher priority than common stock | Highest priority |
| Dividend/Interest | Variable, can be cut | Fixed, must be paid before common | Fixed, legally obligated |
| Voting Rights | Full voting rights | Limited or no voting rights | No voting rights |
| Price Appreciation | Highest potential | Limited upside | Limited to interest rate changes |
| Maturity | Perpetual | Perpetual or callable | Fixed maturity date |
| Convertibility | N/A | Some are convertible to common | Some are convertible to common |
This hybrid nature makes preferred stocks particularly valuable for investors seeking:
- Enhanced income compared to common stocks and many bonds
- Reduced volatility compared to common stocks
- Potential tax advantages compared to corporate bonds
- A middle ground between the growth potential of stocks and the stability of bonds
Types of Preferred Stocks
Preferred stocks come in several variations, each with distinct characteristics that affect their risk and return profiles:
Cumulative Preferred Stock
Key Feature: If a company misses dividend payments, these unpaid dividends accumulate as "dividends in arrears." The company must pay all accumulated dividends before paying any dividends to common shareholders.
Advantage: Provides stronger dividend protection, as missed payments must eventually be made up.
Non-Cumulative Preferred Stock
Key Feature: If a dividend payment is missed, it's gone forever—the company has no obligation to make up missed payments.
Consideration: Generally offers higher yields to compensate for the increased risk of permanently lost income.
Convertible Preferred Stock
Key Feature: Can be converted into a specified number of common shares at the shareholder's option, providing potential for capital appreciation if the common stock rises significantly.
Trade-off: Usually offers lower dividend yields than non-convertible preferreds due to the added conversion feature.
Callable Preferred Stock
Key Feature: The issuing company has the right to redeem (call) the shares at a predetermined price after a specified date.
Risk: Creates reinvestment risk, as shares may be called when interest rates have fallen, forcing investors to reinvest at lower rates.
Adjustable-Rate (Floating-Rate) Preferred Stock
Key Feature: Dividend rate adjusts periodically based on a benchmark interest rate (like Treasury yields or LIBOR/SOFR).
Benefit: Provides protection against rising interest rates, which typically cause fixed-rate preferreds to decline in value.
Trust Preferred Securities
Key Feature: Issued by a special purpose trust established by a corporation, combining features of preferred stock and subordinated debt.
Tax Advantage: Dividend payments are tax-deductible for the issuer, potentially allowing for higher yields.
Key Risk Factors
While preferred stocks offer attractive benefits, they come with several important risk factors that investors should understand:
Interest Rate Risk
Like bonds, preferred stock prices typically move inversely to interest rates. When rates rise, preferred stock prices tend to fall, and vice versa. This is particularly significant for fixed-rate preferreds with longer durations.
Mitigation Strategy: Consider variable-rate preferreds or those with shorter durations during rising rate environments. Ladder maturities if investing in multiple issues.
Credit/Default Risk
The issuing company might face financial difficulties that lead to suspended dividend payments or, in extreme cases, bankruptcy. Since preferreds rank below bonds in the capital structure, they face higher default risk.
Mitigation Strategy: Focus on investment-grade preferred issues from financially strong companies. Diversify across multiple issuers and sectors.
Call Risk
Many preferred stocks are callable, meaning the issuer can redeem them at a predetermined price after a specified date. This often happens when interest rates fall, forcing investors to reinvest at lower rates.
Mitigation Strategy: Be cautious about paying premiums above call price, especially as the call date approaches. Consider non-callable preferreds for longer-term holdings.
Liquidity Risk
Individual preferred issues often have lower trading volume than common stocks, potentially leading to wider bid-ask spreads and difficulty executing trades at desired prices.
Mitigation Strategy: Focus on more liquid issues or use preferred stock ETFs to enhance liquidity. Use limit orders when trading individual preferreds.
Sector Concentration Risk
The preferred stock market is heavily concentrated in financial companies (banks, insurance companies, REITs), creating sector-specific risk.
Mitigation Strategy: Consider ETFs that specifically diversify beyond financials, or manually construct a diversified portfolio of individual issues.
Implementing a Preferred Stock Strategy
Step-by-Step Guide
- Determine your allocation: Decide what percentage of your portfolio to allocate to preferred stocks based on your income needs and risk tolerance. Most income-focused investors allocate 10-20% of their portfolio to preferreds.
- Choose your investment approach: Decide between individual preferred stocks, ETFs/mutual funds, or a combination of both based on your investment amount, expertise, and time commitment.
- Select specific investments: Research and select specific preferred stocks or funds that align with your risk tolerance, yield requirements, and interest rate outlook.
- Implement diversification: Spread your preferred stock investments across multiple issuers, sectors, and types (fixed-rate, floating-rate, etc.) to reduce risk.
- Monitor and manage: Regularly review your preferred holdings for changes in credit quality, call risk, and interest rate sensitivity. Adjust as needed based on changing market conditions.
Investment Approaches
1. Individual Preferred Stocks
Advantages: Higher yield potential, ability to select specific issues matching your criteria, control over credit quality and call features.
Considerations: Requires more research and monitoring, higher transaction costs, need for significant capital to achieve proper diversification (ideally 15+ different issues).
Best for: Larger portfolios ($100,000+ allocated to preferreds), investors with time and expertise to research individual issues.
2. Preferred Stock ETFs
Advantages: Instant diversification, professional management, enhanced liquidity, lower minimum investment requirements.
Considerations: Management fees reduce yield, less control over specific holdings, potential sector concentration (especially in financials).
Best for: Smaller allocations, investors seeking simplicity and diversification, those without time to research individual issues.
Popular Preferred Stock ETFs
For investors seeking diversified exposure to preferred stocks, ETFs offer a convenient solution:
| Ticker | Fund Name | Focus | Dividend Yield | AUM | Expense Ratio |
|---|---|---|---|---|---|
| PFF | iShares Preferred & Income Securities ETF | Broad market | ~5.5% | $14+ billion | 0.46% |
| PGX | Invesco Preferred ETF | Investment grade | ~5.7% | $5+ billion | 0.52% |
| VRP | Invesco Variable Rate Preferred ETF | Variable rate | ~5.3% | $1.5+ billion | 0.50% |
| PFFD | Global X U.S. Preferred ETF | Broad market | ~5.8% | $2+ billion | 0.23% |
| PFXF | VanEck Vectors Preferred Securities ex Financials ETF | Non-financial | ~5.4% | $1+ billion | 0.40% |
ETF Selection Tips:
- Expense Ratios: Lower expense ratios directly enhance your net yield. Compare costs carefully.
- Sector Exposure: Most preferred ETFs are heavily weighted toward financials. Consider PFXF if you want to reduce financial sector exposure.
- Interest Rate Sensitivity: Consider VRP or other variable-rate funds if you're concerned about rising interest rates.
- Credit Quality: Check the credit rating distribution of holdings. Some funds focus more on investment-grade issues, while others include more high-yield preferreds.
- Liquidity: Larger funds (like PFF) typically offer better liquidity with tighter bid-ask spreads.
Selecting Individual Preferred Stocks
For investors who prefer to select individual preferred issues, here are key factors to evaluate:
Evaluation Criteria
- Credit Quality: Review the issuer's credit rating, financial stability, and ability to maintain dividend payments. Investment-grade issues (BBB- or higher) offer greater safety.
- Yield: Compare the current yield to similar preferred issues, accounting for differences in credit quality, call features, and rate structures.
- Call Features: Check if the preferred is callable, when it becomes callable, and at what price. Be cautious about paying premiums for issues near their call date.
- Dividend Type: Determine if dividends are cumulative (missed payments must be made up) or non-cumulative (missed payments are lost forever).
- Rate Structure: Evaluate whether the preferred has a fixed rate, floating rate, or fixed-to-floating structure, and how this aligns with your interest rate outlook.
- Liquidity: Check trading volume and bid-ask spreads to ensure you can buy and sell at reasonable prices when needed.
- Tax Treatment: Verify if dividends qualify for the lower qualified dividend tax rate or are taxed as ordinary income.
Research Resources:
- Preferred Stock Screeners: Use specialized screeners from brokerages like Charles Schwab, Fidelity, or Interactive Brokers.
- Preferred Stock Directories: Websites like QuantumOnline.com offer comprehensive listings of preferred stocks with their features.
- Credit Rating Agencies: Check ratings from S&P, Moody's, and Fitch to assess credit quality.
- Company Financial Statements: Review the issuer's financial health, particularly metrics like interest coverage ratios and debt-to-equity ratios.
- Prospectus Documents: For detailed information on specific issues, including exact terms, dividend policies, and call provisions.
Common Misconceptions
Myth: Preferred Stocks Are Always Safer Than Common Stocks
Reality: While preferred stocks typically have lower price volatility and priority for dividends and assets, they still represent ownership in the company and are subordinate to all debt in the capital structure. During severe financial distress, preferred stockholders can still face significant losses, potentially including complete loss of principal in bankruptcy scenarios.
Myth: Preferred Stocks Provide Both High Income and Growth
Reality: Preferred stocks are primarily income investments with limited price appreciation potential. Unlike common stocks, which can rise substantially with company growth, preferred stocks typically trade within a relatively narrow range centered around their par value (usually $25). The upside is generally capped, while downside risk remains.
Myth: All Preferred Stock Dividends Receive Favorable Tax Treatment
Reality: While many traditional preferred stock dividends qualify for the lower qualified dividend tax rates, certain types—particularly those from trust preferred securities and some foreign issuers—may be taxed as ordinary income. Always verify the tax treatment of specific preferred issues before investing.
Who Should Invest in Preferred Stocks?
Preferred stocks are particularly well-suited for:
- Income-focused investors seeking higher yields than traditional fixed-income investments
- Retirees looking to generate regular income from their investment portfolio
- Investors in higher tax brackets who can benefit from qualified dividend treatment
- Those seeking to reduce portfolio volatility while maintaining reasonable income
- Investors looking to diversify their income sources beyond traditional bonds
- Conservative investors who want some exposure to corporations but with less volatility than common stocks
Advanced Preferred Stock Strategies
Preferred Stock Laddering
Similar to bond laddering, this strategy involves purchasing preferred stocks with different call dates to manage call risk and create regular opportunities for reinvestment. As each issue approaches its call date, you can reinvest in new issues if the original is called, or continue holding if not called.
Barbell Approach
Combine fixed-rate and floating-rate preferred stocks to balance interest rate risk. The floating-rate component provides protection against rising rates, while the fixed-rate portion offers higher current income.
Preferred Stock Arbitrage
For sophisticated investors, opportunities occasionally arise when a company's preferred shares trade at significant discounts to their intrinsic value or relative to other securities in the same capital structure. This might involve purchasing undervalued preferred shares while hedging with common stock or other related securities.