As investors navigate the complex world of finance, they often find themselves torn between the desire for high returns and the need for stability. While common stocks offer the potential for significant growth, they also come with a higher level of risk. Bonds, on the other hand, provide a relatively stable source of income, but often with lower returns. However, there is a third option that can offer the best of both worlds: preferred stock. In this article, we will explore the benefits of investing in preferred stock and why it can be a smart choice for savvy investors.
What is Preferred Stock?
Before we dive into the benefits of preferred stock, it’s essential to understand what it is. Preferred stock is a type of equity security that has a higher claim on assets and dividends than common stock. It is called “preferred” because it has a higher priority than common stock in the event of liquidation or bankruptcy. Preferred stock typically does not come with voting rights, but it offers a fixed dividend rate, which can provide a relatively stable source of income.
Key Characteristics of Preferred Stock
Preferred stock has several key characteristics that distinguish it from common stock and bonds. Some of the most important features include:
- Fixed Dividend Rate: Preferred stock typically offers a fixed dividend rate, which can provide a relatively stable source of income.
- Higher Claim on Assets: Preferred stock has a higher claim on assets than common stock, which means that preferred shareholders are more likely to receive their investment back in the event of liquidation or bankruptcy.
- No Voting Rights: Preferred stock typically does not come with voting rights, which means that preferred shareholders do not have a say in the company’s operations.
- Redeemable: Preferred stock is often redeemable, which means that the company can buy back the shares at a predetermined price.
Benefits of Investing in Preferred Stock
So, why should investors consider adding preferred stock to their portfolio? Here are some of the key benefits:
Relatively Stable Source of Income
One of the most significant benefits of preferred stock is that it offers a relatively stable source of income. The fixed dividend rate provides a predictable stream of income, which can be attractive to investors who are looking for a regular return on their investment.
Example of a Preferred Stock with a High Dividend Yield
| Company | Preferred Stock Symbol | Dividend Yield |
|---|---|---|
| AT&T Inc. | T-PRA | 4.63% |
As you can see from the example above, AT&T’s preferred stock (T-PRA) offers a dividend yield of 4.63%, which is significantly higher than the yield on many bonds.
Lower Volatility
Preferred stock is often less volatile than common stock, which means that it can provide a more stable source of returns. This is because preferred stock is less sensitive to changes in the company’s stock price, as the dividend rate is fixed.
Comparison of Volatility between Preferred Stock and Common Stock
| Company | Preferred Stock Symbol | Common Stock Symbol | Volatility (Beta) |
|---|---|---|---|
| AT&T Inc. | T-PRA | T | 0.35 (T-PRA) vs. 0.63 (T) |
As you can see from the example above, AT&T’s preferred stock (T-PRA) has a beta of 0.35, which is significantly lower than the beta of its common stock (T), which is 0.63.
Higher Claim on Assets
Preferred stock has a higher claim on assets than common stock, which means that preferred shareholders are more likely to receive their investment back in the event of liquidation or bankruptcy.
Example of a Company with a High Level of Debt
| Company | Debt-to-Equity Ratio |
|---|---|
| Sprint Corporation | 4.34 |
As you can see from the example above, Sprint Corporation has a debt-to-equity ratio of 4.34, which is relatively high. In this scenario, preferred shareholders would have a higher claim on assets than common shareholders.
Risks of Investing in Preferred Stock
While preferred stock can offer a relatively stable source of income and lower volatility, it is not without risks. Some of the key risks include:
Interest Rate Risk
Preferred stock is sensitive to changes in interest rates, which means that when interest rates rise, the value of preferred stock can fall.
Example of the Impact of Rising Interest Rates on Preferred Stock
| Company | Preferred Stock Symbol | Price Change (1-Year) |
|---|---|---|
| AT&T Inc. | T-PRA | -5.12% |
As you can see from the example above, AT&T’s preferred stock (T-PRA) fell by 5.12% over the past year, largely due to rising interest rates.
Call Risk
Preferred stock is often callable, which means that the company can buy back the shares at a predetermined price. This can result in a loss of income for investors.
Example of a Preferred Stock with a Call Feature
| Company | Preferred Stock Symbol | Call Price |
|---|---|---|
| Verizon Communications Inc. | VZA | $25.00 |
As you can see from the example above, Verizon’s preferred stock (VZA) has a call price of $25.00, which means that the company can buy back the shares at this price.
Conclusion
Preferred stock can offer a relatively stable source of income and lower volatility, making it an attractive option for investors who are looking for a regular return on their investment. However, it is essential to understand the risks associated with preferred stock, including interest rate risk and call risk. By carefully evaluating the benefits and risks, investors can make an informed decision about whether preferred stock is right for their portfolio.
Final Thoughts
Preferred stock can be a smart investment choice for savvy investors who are looking for a relatively stable source of income and lower volatility. By understanding the benefits and risks, investors can make an informed decision about whether preferred stock is right for their portfolio. As with any investment, it is essential to do your research and consult with a financial advisor before making a decision.
What is preferred stock and how does it differ from common stock?
Preferred stock is a type of stock that has a higher claim on assets and dividends than common stock. It is called “preferred” because it has a higher priority in case the company goes bankrupt or is liquidated. Preferred stock typically does not come with voting rights, but it offers a fixed dividend rate that is usually higher than the dividend rate of common stock.
Preferred stock is often considered a hybrid security because it combines features of both stocks and bonds. Like bonds, preferred stock offers a fixed income stream, but like stocks, it represents ownership in a company. This makes preferred stock an attractive option for investors who want to earn a regular income without taking on too much risk.
What are the benefits of investing in preferred stock?
One of the main benefits of investing in preferred stock is the potential for higher dividend yields compared to common stock. Preferred stock typically offers a fixed dividend rate that is higher than the dividend rate of common stock, making it an attractive option for income-seeking investors. Additionally, preferred stock has a higher claim on assets and dividends than common stock, which means that investors are more likely to receive their dividend payments.
Another benefit of investing in preferred stock is the relatively lower volatility compared to common stock. Preferred stock prices tend to be less volatile than common stock prices, which means that investors are less likely to experience significant losses. This makes preferred stock an attractive option for investors who want to earn a regular income without taking on too much risk.
What are the risks associated with investing in preferred stock?
One of the main risks associated with investing in preferred stock is the risk of default. If the company is unable to pay its dividend payments, investors may not receive their expected income. Additionally, if the company goes bankrupt or is liquidated, preferred stockholders may not receive their full investment back.
Another risk associated with investing in preferred stock is the risk of interest rate changes. When interest rates rise, the value of preferred stock may decline, which means that investors may experience losses if they sell their shares. This is because preferred stock is often priced relative to the yield on bonds, so when interest rates rise, the yield on bonds also rises, making preferred stock less attractive.
How do I invest in preferred stock?
Investing in preferred stock is relatively straightforward. Investors can purchase preferred stock through a brokerage firm or online trading platform. They can also invest in preferred stock through a mutual fund or exchange-traded fund (ETF) that specializes in preferred stock.
Before investing in preferred stock, it’s essential to do your research and understand the terms and conditions of the investment. Investors should carefully review the prospectus and other disclosure documents to understand the risks and benefits associated with the investment. They should also consider their investment goals and risk tolerance before making a decision.
What are the tax implications of investing in preferred stock?
The tax implications of investing in preferred stock depend on the type of preferred stock and the investor’s tax status. In general, the dividend income from preferred stock is taxable as ordinary income. However, some types of preferred stock, such as qualified dividend-paying stock, may be eligible for a lower tax rate.
Investors should also be aware of the potential for capital gains tax if they sell their preferred stock for a profit. The capital gains tax rate depends on the investor’s tax status and the length of time they held the stock. Investors should consult with a tax professional to understand the specific tax implications of their investment.
Can I invest in preferred stock through a retirement account?
Yes, investors can invest in preferred stock through a retirement account, such as a 401(k) or IRA. In fact, preferred stock can be a popular investment option for retirement accounts because it offers a regular income stream and relatively lower volatility.
Investors should check with their retirement account provider to see if they offer preferred stock as an investment option. They should also consider their investment goals and risk tolerance before making a decision. It’s essential to carefully review the terms and conditions of the investment and understand the fees associated with the account.
How do I evaluate the creditworthiness of a preferred stock issuer?
Evaluating the creditworthiness of a preferred stock issuer is crucial to understanding the risk of default. Investors can evaluate the creditworthiness of an issuer by reviewing their credit rating, financial statements, and industry trends.
Investors should look for issuers with a high credit rating, such as investment-grade, and a strong financial position. They should also review the issuer’s financial statements to understand their revenue, expenses, and cash flow. Additionally, investors should consider industry trends and the issuer’s competitive position to understand their potential for long-term success.