Preferred Stock is Not for Individual Investors At this Point In the Economic Cycle

Preferred stock is a form of equity issued by a company. It ranks senior to common equity in dividend disbursement and dissolution matters, but subordinate to all debt issuances of the company. Preferred stock, however, was never designed for individual investors; rather, it is largely a creation of the IRS which allows companies to exclude 70% of the dividend income received from preferred stock.

Even though individuals cannot benefit from the favorable tax attributes of preferred stock, some individuals have found them appealing because of the dividend with some preferred issuances yielding in the 6 to 7% range. As a result, many investment advisors refer to preferred stock as a hybrid security, and argue that it combines the attractive features of equities with those of bonds. Unfortunately, they also contain many negative attributes which should be understood before investing in them.

Preferred dividends are ordinarily not as well protected as a bond. In a so-called non-cumulative preferred stock issue, dividends can be missed if not ratified by the board and do not build up in arrears. In order words, these dividends do need to be paid before any dividends can be paid to common holders. With so-called cumulative preferred stock, all back dividends need to be paid before distributions can be made to equity holders, but these issues still lack the legal indenture associated with bond issues.

Preferred stock does not allow the investor to participate in a company’s upside. While some preferred stock is convertible into common stock, most is not. In fact, preferred stock is ordinarily callable by the company at par, which makes any market appreciation unlikely.

Since preferreds are ordinarily issued in perpetuity (i.e., with no redemption date), they will decline in value much more quickly in a rising interest rate environment. Whereas with bonds, particularly short-term bonds, investors who do not require immediate liquidity can always wait for the bonds to mature in order to be redeemed at par, holders of preferred stock have no date certain on which they are due to be redeemed.

In 2008 some of the largest preferred issues in the US came under severe pressure. Preferred holders learned the hard way that preferred don’t have the benefits of debt in a dissolution or bankruptcy (GM) and were often forced to convert their stake to common equity with significant losses (Citibank, Bank of America).

Many investors today are putting money into preferred issuances and taking a gamble that they will be able to get out whole after the first Fed raise. To be clear, at that point you will have already lost money.

Full Disclosure: The author does not own any preferred stock. The only preferred issuance that he finds at all interesting are the preferred issuances of Public Storage (NYSE: PSA) which are yielding approximately 6.5%. But, he finds PSA’s common stock - paying a 3% yield and allowing participation in the company’s upside – to be a much more attractive proposition.