What is preferred stock?

Preferred stock or preferred shares are sort of a blend of stocks and bonds. Like stocks, you're buying equity in the company. Like bonds, dividend payments are a fixed percentage of the par value or face value of each share.

Corporations use preferred shares to raise capital. In the U.S., they tend to be issued by banks, utility companies, and real estate investment trusts or REITs.

In this post, I'll walk you through what they are, how to research them, and how you can invest in them.

Reminder before we continue: I'm not a financial professional or investment pro. I just read a lot. You may want to consult someone who knows what they're doing before you take action on anything I've written here.

Preferred share ticker symbols are weird and inconsistent across brokerages and media outlets. For example, Wells Fargo Series L shares are listed as WFC-L on Google Finance, WFC-PL on Yahoo! Finance, and WFC.PRL on Marketwatch. You may also see preferred shares displayed with a / after the ticker symbol (i.e. WFC/PL), or without any punctuation involved (i.e. WFCPL or WFCPRL).

Why buy preferred shares?

• You want predictable income, paid quarterly.
• You want higher yields than you can get from common stock dividends.
• You don't care about having a say in how the company is run.
• You don't have a few thousand dollars for bond purchases.

Preferred shares are all about income. They typically offer higher dividend yields than shares of common stock, with a better chance of price appreciation than bonds.

For example, American Homes 4 Rent (ticker symbol AMH) last paid shareholders a $0.22 quarterly dividend. If the dividend doesn't change, shareholders will earn $0.88 per share over the course of a year. At its current share price (somewhere between $28 and $31), that works out to a yield of about 2.89 percent.

American Homes 4 Rent also offers preferred shares. Its G series has a coupon rate of 5.875 percent, and a par value of $25 per share. That works out to $1.468 per share per year, or $0.367 per quarter. At its current price of about $22.55 per share, AMH.PRG has an even better yield¹ of 6.5 percent.

Preferred shares usually have a par value of $25 or $100, versus the $1,000 par value of bonds. Usually doesn't mean always, however. Wells Fargo's WFC.PRL has a par value of $1,000. Generally, though, you'll pay less for preferred stock than you would for common stock issued by the same company.

As a preferred shareholder, you'll receive dividend payments until the shares reach their maturity date, or the issuer calls (redeems) them.

Slightly lower risk of principal loss compared to common stocks

Preferred shares are called preferred because they receive preference or priority for dividend payments compared to common shares. If there's enough money for a dividend, preferred shareholders must get paid before common shareholders do.

Preferred shares also have a higher priority than common shares when it comes to liquidation events such as bankruptcies. If there is anything left after debt holders (bond owners) receive their cut, preferred shareholders are next in line. Hopefully, though, your investment will never get to that point, or you'll be able to sell before it does.

Why avoid them?

So far, preferred shares sound great, right? As with most investment products, however, preferred shares are not without risks and downsides.

Interest rate risk

Preferred share pricing works similarly to bond pricing. When interest rates increase, the price (or value) of preferred shares can fall. As newer issues with higher yields become available, your shares become less desirable to other investors. You'll still receive dividend payments, but if you sell your shares, you'll probably sell at a loss.²

Price risk

Preferred share values may also fall if the business experiences a rough patch. If a company can no longer pay a dividend, your shares may be worthless for awhile.

Preferred share prices can and do go up. But you won't see the kind of huge price growth that you often get with common shares. AMH.PRG, for example, has stayed between $20 and $27 per share. AMH common shares have sold for as little as $15.83 and as much as $43.61.

Call risk

Should interest rates fall far enough, the issuer will most likely call your shares.

Like bonds, preferred stocks can be called (redeemed). When a preferred share gets called, the issuer pays the shareholder the par value, plus any outstanding dividends. The issuer may also pay the shareholder a premium for early redemption, depending on the terms of the prospectus.

Corporations may call shares when interest rates drop, so that they can issue shares with a lower dividend yield. That saves the corporation money over the long run. It may also throw off your fixed income plans.

These risks are similar to what you get with investment-grade bonds.

Credit and payment risk

Corporations do not have to pay dividends. That's true even for preferred shares. A risk of missed payments is one reason why preferred shares offer such high yields.

When it comes to payments, preferred shares can be one of two types:

• cumulative: which means you'll receive your dividend payments eventually, but they might be late.
• non-cumulative: you won't get a dividend payment … like at all.

As with common stock, missed dividend payments are not considered a default. In general, though, if a company is healthy enough to pay a dividend, you'll receive a dividend payment.

No voting rights

With common stock, you can vote your shares in a proxy vote. Preferred shares do not get a say in corporate governance.

Unless you own a lot of common shares, however, you're probably being outvoted by Carl Icahn or BlackRock fund managers or something. You weren't getting all that much of a say anyway. A lack of voting rights isn't necessarily a reason to avoid preferred shares.

Hard to research

Preferred shares are also notoriously hard to research. Preferred shares are usually offered to institutional investors — endowments, mutual funds, hedge funds, pension funds, banks, large unions, family offices, insurance companies, sovereign wealth funds, and the like. Us commoners get to buy them on the secondary market (i.e. through a stock exchange).

If you try to research preferred shares, you'll usually come up empty. Most brokerages and media outlets provide data on the issuer, but not the preferred share offering. I'm only slightly embarrassed to admit that my approach has been to buy a few shares of seemingly healthy companies (Wells Fargo, JPMorgan) and hope for the best.

Researching preferred shares

So far my strategy has worked out. You, on the other hand, may wish to do some due diligence.

Start with EDGAR. It's a service of the United States Securities and Exchange Commission. You can search by the corporation's name, or its common stock ticker symbol. You can also search by keyword and document type. Limit your search to Registration statements and prospectuses.

A few questions to ask and answer as you read the prospectus.

• What's the call date? The call date is the date on or after which the shares can be redeemed by the issuer.
• Is there a maturity date or are they perpetual shares?
• What kind of seniority do the shares have? What happens to the shares if the company gets acquired or goes bankrupt?
• Are dividend payments cumulative or non-cumulative?
• Are dividend payments qualified and subject to a lower capital gains tax rate, or are they taxed as ordinary dividends?
• Can preferred shares be converted to common shares? What are the conditions of such a conversion?

Ratings agency Moody’s makes some of their ratings available with a free account. Among other things, Moody’s grades the credit risk of bonds, preferred shares, and securitized debt. You can search their database for the CUSIP number of your shares and find its rating and outlook, along with the rating and outlook of the issuing entity.

Review SEC filings and professional analysis for the issuer too. You can do that using EDGAR and your brokerage account tools. Marketwatch, Yahoo! Finance and Google Finance provide similar tools.

Finding preferred shares

So how do you find preferred shares? I found our first shares on a lark. I was searching JPMorgan's ticker symbol JPM. That search also returned a result for JPM.PRD, JPMorgan's 5.75% depositary shares. If you have a company in mind, that's one way to find out whether they have preferred shares available.

A more fruitful strategy: use a stock screener. Fidelity has an old, kludgy, but publicly-accessible preferred security screener. You won't be able to see the details for a security without a Fidelity account, but you can at least see what's available. Other brokerages and media companies offer screening tools to their clients and subscribers.

You can also invest in preferred shares through a fund. Funds hold shares of different companies, which mitigates your risk of loss from investing in any one company. Global X Us Preferred ETF and iShares Preferred and Income Securities ETF are two low-cost options. Research agency Morningstar offers a few more recommendations.

Conclusion

Preferred shares offer both the best and worst of stocks and bonds in one instrument. I think they're worth investing in, but be aware of the risks.

Preferred shares currently make up about 2 percent of our portfolio. I wouldn't invest more than 5 percent in any one corporation — same as with common stock.