Trivia question: what security trades like a bond, offers high yield like a bond, has just a little less safety than a bond but more than a stock, and was an exotic security until a few years ago?
Preferred stock!
Although this is LearnBonds.com, it is essential you learn about preferred stock because it is a great way to diversify your long-term diversified income portfolio.
It’s best to think of preferred stock is as a stock-bond hybrid, because it shares characteristics of both.
A stock gives you an actual ownership piece in a company. A bond is a loan to a company, in which you receive an interest payment in exchange. A bond puts you in the most advantageous position to get back what is due if the company files for bankruptcy. Both stock and bonds are used so a company can finance some activity it wants to engage in.
Preferred stock allows a company to raise money without diluting the ownership of other shareholders, while also allowing current bondholders to maintain their ability to seize the company if something really bad happens to it.
For example, Company X may issue 10,000,000 Series A preferred shares at $25/share to raise $250 million. The price the preferred stock is offered at is called the fixed liquidation value, or par value (just like a bond).
So if Company X gets liquidated, holders of preferred stock should get $25 per share after bondholders get repaid. This is the advantage of preferred stock. Its owners are behind bondholders but ahead of common stock holders.
The other advantage of preferred stock is that the company can miss a payment and not go into default, thereby risking the whole business, as is the case with bonds. Instead, unpaid preferred payments usually accrue until the company can pay those dividends again.
The trading price of preferred stock is often in a tight range. That’s because they trade more like bonds than stocks — the price often reflects the market’s confidence in the company’s financial strength.
Just like a bond, the price relative to par indicates the market’s confidence in the company’s solvency. Many preferred stocks were far below par in the financial crisis, and provided holders with huge capital appreciation afterwards. Otherwise though, you are really buying preferred stock for the yield…and that yield tend to be much higher than highly-rated bonds. AAA-rated bonds won’t yield much because there isn’t much risk. I love preferred stock because I believe they yield much more than they should given their true risk.
The dividend is usually stated as a percentage of the par value — the price at which the preferred stock was issued. Using our example, Company X would issue 10,000,000 shares of 8% Series A preferred Stock at $25/share. This means the preferred shares pay 8% of $25 per year, or $2 per share.
If a company is facing a liquidity crunch, it can suspend the payment of the preferred dividend. With bonds, if a company misses an interest payment, it usually triggers a default on the loan and the company can be taken over by bondholders. Preferred stockholders have no such power. They just hold on and hope the company recovers enough to start paying that dividend again. They also have another advantage over the common shareholders, in that the common stock dividend must be suspended first before the preferred dividend gets altered.
As mentioned, not only were preferred stocks selling for below par in the financial crisis, many of them suspended their dividend payment.
The one other aspect of preferred stock is whether it is callable. “Callable 2018” means Company X’s $25 share price is also the price at which the company could call the stock. That is, beginning in 2015, Company X can buy back the Series A stock at $25 per share, and holders can’t refuse. The company would probably only do this if the stock trades at over $25, so they’d get it back at a discount to market price, or they think it’s better to spend the money in one lump sum rather than continually paying out dividends.
Next time, I’ll offer my criteria for when to buy preferred stock and make some suggestions.
So how does one find a preferred stock worth trading? Everyone has different criteria, but here are the things I focus on.
About Lawrence Meyers – Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected].
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