How Do Preferred Stocks Work?

posted on 06-07-2019

With cash and Treasuries yielding next to nothing, yield-hungry investors may find themselves scratching their heads in search of a safe place to park their money. In such a case, preferred stocks may be just what the doctor ordered.

For the risk-averse investor, preferred stocks can be preferable to high-yielding common stocks because payouts are more secure than common share dividends. Preferred shareholders have a claim to a company's assets ahead of common shareholders -- that's why they're called "preferred." In other words, if a company ran into trouble, it must pay preferred dividends before common-stock dividends. And unlike common dividends, preferred payouts are predictable -- they don't go up and down with a company's earnings.

The fixed payments also tend to make share prices on preferred stocks far less volatile than common shares. But before you dive into any investment, it's important to check out the fine print. That rule applies even more so to preferred stocks, which can be tricky due to the options available.

What's the Yield?
All preferreds have a stated coupon rate, which is generally included in its name. The coupon rate multiplied by the par value (the issue price) of a share gives you the amount you can expect to receive annually. For example, a preferred stock with a $25 par value and an 8% coupon would pay an investor dividends of $2.00 per share over the course of the year. Investors should note that the coupon rate can be different from the market yield. If the shares with an 8% coupon traded for $28 instead of $25, then the market yield would be a bit over 7% ($2/$28).

What About the Tax Bite?
The full name of a preferred stock will usually contain one of these words: "traditional" or "trust." Traditional preferred stocks are considered equity, and as such, dividends usually qualify for the lower 15% dividend tax rate. Uncle Sam takes a bigger tax bite out of the more common trust preferreds, which are considered debt. Payouts on those are taxed as ordinary income -- up to a 35% rate.

The tax advantage of traditional preferreds is useful if you hold your investments in a taxable account. Otherwise, payments on trust preferreds are somewhat more secure -- as debt, they have a prior claim on a company's assets if the firm runs into trouble.

Are the Dividends Secure?
Like bonds, preferred shares are rated by credit agencies such as Standard & Poor's and Moody's. An investment-grade credit rating of "BBB-" or higher from Standard & Poor's or "Baa3" or higher from Moody's gives you some assurance that your income is secure, and there's little chance of the company defaulting on the payments.

To check out the tax treatment or credit rating on a preferred share issue, you can ask your broker or visit a free online site like QuantumOnline.com before you make a purchase decision. Remember -- these credit ratings are helpful, but not foolproof. Some preferred stock issues may be equally secure as others, but have no credit rating.

Are the Dividends Cumulative?
Preferred stock dividends also come as either "cumulative" or "non-cumulative." With non-cumulative shares, if a company suspends dividend payments, they won't be paid later. In contrast, cumulative shares mean that if the dividends aren't paid, they accumulate from year to year until payment. Say the company faces a cash crunch and has to suspend all of its dividends. If they are cumulative, the firm can't pay dividends to the common shareholders until it has first paid all the dividends that it missed to preferred shareholders.

When is it Called and Does it Mature?
Most preferreds have a "call date." On this pre-set date or anytime after, the issuer has the option to buy back the shares from you. If the company decides to do that, they would pay you the par value in cash for each share you own. Companies don't call their preferreds very often since they have to come up with the cash to do it.

Some preferred shares may also have a "maturity date." When the shares mature, the company gives you back the cash value of the shares when issued. Maturity dates give you some downside protection, since no matter how low the price goes while you're holding a preferred stock, at maturity you will get back the issue price (unless the company goes bankrupt or liquidates).

How Frequent Are Payments?

You also want to check on the frequency of the payments. Some preferreds dish out dividends quarterly, but many offer monthly payments. These compound a bit faster in your account, plus receiving a check every month can be handy when you are retired.  Click here to read about the advantages of compounding monthly dividends.

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