You may find preferred stock an attractive alternative to bonds as an income-producing investment. Preferred shares pay fixed dividends and yields are often higher than bond yields. There is more risk with preferred stock than with bonds, but less risk than with common stock. The factors that influence the value of preferred stock are similar to those that affect bond prices.
What Is a Preferred Stock?
A preferred stock pays a fixed dividend amount that is stated in the share prospectus at the time the shares are originally sold. A corporation that issues preferred shares is obligated to pay the dividend as long as it is able to do so. These characteristics cause the prices of preferred stocks to vary in a fashion much like corporate bond prices. In fact, Charles Schwab says preferred stock can be viewed as a hybrid of a common stock and a bond. Preferred stock prices tend to be less volatile than those of common shares and carry less market risk. On the other hand, preferred stocks generally do not have the growth potential of common stocks.
Investors buy preferred stocks mainly because of the dividends they pay. This means a preferred stock competes against other interest-bearing securities for buyers. If market interest rates rise, the dividend paid by a preferred stock is less attractive, so the per share price is likely to drop. Conversely, if interest rates go down, a preferred stock offers a relatively better return. Demand for the shares increases and usually drives the price up.
If a company becomes insolvent, preferred shareholders may or may not get back the money they have invested. Ratings services like Moody’s, Fitch Ratings and Standard & Poor’s publish ratings of preferred stock issues, just as they do for bonds. A downgrade in a stock’s rating will generally result in a drop in the share price. Preferred shares carry more credit risk than bonds because bondholders must be paid first in the event a company is liquidated. For this reason, preferred shares are often rated a little lower than bonds issued by the same company.
Some preferred stocks offer features that make them more attractive to investors, who will pay a higher price than for stocks with the same dividend payment but that lack added incentives. For example, participatory preferred stocks may pay extra dividends if the company’s earnings justify doing so. Many preferred stocks are cumulative, meaning that any missed dividends accumulate and will be made up when the company is able to do so. However, some preferred stocks have negative features. Callable preferred shares may be bought back at the company’s discretion. If a company chooses to call these shares, the investor loses the opportunity to earn good dividends and thus is generally willing to pay less for callable preferred shares.