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Preferred
Stocks
What You Need to Know
by Harry Domash
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Overview
About
Corporations issue preferred stocks to raise cash. Although you buy
or sell them the same way you trade regular stocks, preferreds are more like bonds than common stocks. Investors buy them for
the steady dividends, which typically equate to 4% to 8% yields. Most
preferreds pay dividends quarterly.
Unlike common stocks, you’re won’t enjoy much share price appreciation
if your company comes up with a hot product. Further, in most cases, the
dividend never goes up either.
The term “preferred” means that a firm must pay the dividends due on its
preferred shares before it pays any common stock dividends.
Also, in theory, if a company goes bankrupt, preferred holders have
priority over common stock shareholders. However, when a company fails,
both common and preferred shareholders usually get nothing.
Finally, another meaningless distinction: unlike common stock holders,
preferred shareholders don’t get to vote on company proposals. But, in
fact, individual common shareholders have almost no influence on any
corporation's policies.
Nuts & Bolts
When a company issues a preferred stock, it sets the annual dividend and
sells the shares at a preset price, typically $25, but some are issued
at $50 or $100.
The initial yield, called the “coupon rate,” is the annual dividend
divided by the issue price. For instance, the yield on shares paying
$1/year on shares issued at $25 is 4%.
However, since preferreds trade on the open market just like
regular stocks, the actual trading price depends on supply and demand.
Thus, if the shares mentioned above slip to $24, the yield to new
investors (market yield) rises to 4.2% ($1 divided by $24).
Ticker Symbols
Companies that issue preferred stocks typically sell more than one
series, for instance, Series A, Series B, etc. Ticker symbols are
usually the issuing firm’s ticker followed by a “-“ and then the series
identifier. For example, the ticker for Bank of America’s “I” series
preferreds is “BAC-I”. MSN Money’s (moneycentral,msn.com)
Company Report is a good place to see current prices and trading
volumes.
Call
Prices & Total
Returns
Calling Preferreds
Preferreds have minimum 30-year maturities and some are perpetual,
meaning that the firm is not obligated to redeem them. However, most
preferred stocks are “callable,” meaning that the issuer has the right
to call (redeem) them at the “call price” after a specified date (call
date), typically five-years after issue. The call price is usually the
original issue price, but under certain conditions it may be slightly
higher.
The issuer is not obligated to redeem the shares at the call
date. Issuers are likely to call their preferreds if interest rates have
dropped and they can save money by calling existing preferreds and
selling a new batch paying lower rates. Thus, depending on prevailing
interest rates, preferreds might continue to trade for years after the
call date.
Nominal Yield
A preferred stock's coupon rate defines its annual dividend, but not the yield
that you would receive if you bought the preferreds after the issue
date. For instance, A 7.0% bond issued at $25 pays $1.75/share annually
(7% of $25). If the price drops and you only pay $23.00 per share, your
nominal yield would be 7.6% ($1.75 divided by $23). On the other hand,
your yield would drop to 6.7% if you pay $26 for the shares, which still
might be acceptable, depending on what banks are paying at the time.
Yield to Call
For preferreds near or already past their call dates, it’s important to
know your potential return should they be called. For instance, say that
you pay $26 per share for 7.0% (coupon rate) preferreds originally
issued at $25 per share that can be called in 12-months. Even
though you're collecting a nominal 6.7% yield, you would lose $1/share
in 12-months if the shares were called at that time. Factoring that in,
your actual return, called the "yield to call," would drop to 2.9%.
Rather than doing the math yourself, use this
handy calculator to determine your preferred's yield to call.
Potential Price Appreciation
Ideally, you would like to buy preferreds below their issue
price. Assuming that the issuing corporation is a solid player and won't
renege on its dividend obligations, the preferreds will eventually move
back up to their issue price. If that happens, you would enjoy capital
appreciation in addition to the dividends. For instance, suppose that
you buy shares originally issued at $25, but currently trading at $23.
Your capital appreciation potential is 8.7%., and your nominal dividend
yield is 7.6%.
Obviously, thanks to the capital appreciation potential, the call date
isn't an issue when you buy preferreds trading below their call price.
For example, for the 7.0% coupon preferreds trading at $23, your yield
to maturity would be 16.3% if they were called 12-months after you
purchased.
Preferred
Stock Risks
Preferred stock investors face three major risk factors: 1) dividend
suspension or company failure, 2) rising interest rates, and 3) low
trading volumes.
Dividend Suspension/Company Failure
Firms that are facing cash flow problems will be tempted to suspend
paying preferred stock dividends, and in the worst case, might file for
bankruptcy. Either of those events would sink preferred share prices.
Consequently, preferred investors must understand the issuing
corporation's fundamental outlook. Preferreds issued by marginal
corporations will look tempting because they will be
trading at big discounts to their issue price. Thus, be sure to do your
homework before buying preferreds in that category.
Many preferred stocks are rated by bond rating agencies such as Moody's and
Standard & Poor's. They use a combination of letters, numbers, and plus
or minus signs such as AAA, BA1 or B- to rate the preferreds.
The details vary between agencies, but all ratings starting with A, and
three letter ratings starting with B, indicate investment quality.
S&P:
Investment quality ratings are AAA, AA, A, and BBB. Below investment
quality ( best to worst) are BB,
B, CCC, CC, C and D. S&P may add a “+” or “-“ to indicate
that a rating falls near the top or bottom of a rating category.
Moody’s
investment quality ratings, are Aaa, Aa, A, and Baa. Below investment
quality (best to worst) are Ba, B, Caa, Ca, and C. Moody’s may add a “1,” “2,” or “3” to a rating
to indicate that it falls near the top or bottom of a rating category (1
is best).
Since issuers must pay Moody’s or S&P to be rated, not all preferreds
are rated. Unrated preferreds aren’t necessarily risky, but they require
more work since you’ll have to do the financial strength analysis on
your own.
Beware; bond-analysts sometimes overlook the obvious. For instance, in
2007, many didn’t realize that falling home prices would
reduce the value of mortgages secured by those homes. Thus, it’s up to
you to keep up with the news and avoid industries with obvious problems.
Interest Rate Risk
After the issuing company's financial outlook, prevailing interest rates are the most important factor controlling
preferred share prices. If market rates rise, preferred stock prices will
probably drop, and vice versa. Here’s why.
Suppose that you own preferreds paying an initial 6% dividend yield; for
instance, a preferred issued at $25 that pays dividends totaling $1.50
annually. Now, say that prevailing corporate rates rise to 7%. There
would be no market for preferreds paying 6% at $25 per share. Instead,
buyers would only be willing pay $21.43 per share. At that price, the
$1.50 annual dividend would equate to a 7% return ($1.50 divided by
$21.43 is 7%).
Conversely, if interest rates drop, investors would be willing to pay
more for you shares because they are yielding better than market
returns. Thus, the best time to own preferreds is when the outlook for
corporate
interest rates is steady or headed down.
Trading Volumes
Some preferred stocks are not widely followed and are lightly traded.
Those are risky business because the lack of trading volume makes it
difficult to move in or out of a position at a reasonable price. Avoid
preferred stocks trading less than 4,000 shares daily, on average.
Preferred
Stock Tax
Issues
For reasons too involved to detail here, the dividends from some
preferreds are subject to the maximum 15% dividend tax rate, while
others are taxed as ordinary income. That can make a big difference. For
instance, $1.00 of dividends taxed at 15% nets out to roughly the same
amount as $1.30 taxed at the maximum 35% ordinary tax rate. For each
preferred, Quantum Online (www.quantumonline.com)
specifies whether the 15% maximum rate applies.
Corporations that have invested in other firm’s preferred shares, in
most instances, enjoy a dividend received deduction that allows them to
exclude 70% of dividends received from their taxable income. Quantum
Online also specifies whether each preferred qualifies for the corporate
dividend received deduction.
Evaluating Preferred
Stocks
Evaluate preferreds by analyzing the issuing company’s financial
strength. What’s important is that the firm has the cash to pay its
dividends. It doesn’t matter if the issuer’s earnings came in below
analysts’ estimates or it said next quarter sales would be lower than
previously forecast.
Here
are some selection criteria to keep in mind.
•
Current Price vs. Call Price: ideally, the current price would be no higher than
call price, and preferably lower.
•
Credit Rating: should be investment grade (any rating starting with "A"
and three-letter "B" ratings) unless you're up to analyzing
the issuing firm's balance sheet on your own.
•
Trading Volume: minimum 4,000 shares, traded daily, on average.
•
Issuing Company Analyst Consensus Buy/Sell Rating: hold or better.
•
Issuing Company Return on Assets: 6% or higher.
•
Issuing Company trailing 12-months (TTM) Operating Cash Flow: positive.
Preferred Stocks Glossary
Adjustable Rate: annual dividend varies depending on predefined
factors.
Callable: issuer has the right to redeem shares at issue price
after a specified date.
Call Date: earliest date that shares can be called. Usually five
years after issue date.
Call Price: price issuer will pay for redeemed shares. Usually
the same as the issue price.
Convertible: holders have the right to convert preferred shares
to common stock at predetermined ratio after specified date. This gives
preferred holders a chance to benefit from the common stock’s share
price appreciation.
Coupon Rate: yield based on initial issue price
Cumulative: skipped dividends must still be paid before common
stock dividends are paid and before the shares are redeemed.
Current Yield: yield based on current share price.
CUSIP: unique identifier for each security.
Exchange-Traded Debt Securities: a.k.a. Preferred Equity Traded
(PET) Bonds or Junior Subordinated Debentures. Debt securities such as
debentures, notes and bonds that trade like stocks. These unsecured debt
instruments rank below secured debt, but senior to preferred and common
stocks.
Ex-Dividend Date: you must purchase shares prior to the
ex-dividend date to receive the corresponding payout.
Issue Price: original share price.
Liquidation Value: same as issue price.
Market Yield: same as current yield.
Maturity Date: the date the preferred shares must be redeemed by
the issuing firm, typically 30 to 100 years after issue.
Par Value: same as issue price
Participating: annual dividend varies depending on firm’s net
income or dividends paid to common shareholders.
PINES (Public Income Notes): a.k.a. QUIBS (Quarterly Interest
Bonds) or QUIDS (Quarterly Income Debt Securities). Debt securities such
as debentures, notes and bonds that trade like stocks. These senior
unsecured debt instruments rank below secured debt, but senior to
preferred and common stocks.
Redeemable: same as “callable.”
Redemption Date: same as call date.
Third Party Trust Preferred: a Trust Preferred issued by a third
party such as an underwriter.
Trust Preferred Securities: a cumulative preferred variation that provides certain
income tax and accounting advantages over traditional preferreds to the
issuer, but not for the shareholder. Instead of selling preferreds
directly, a corporation sets up a special trust that buys debt
securities from the corporation and, in turn, issues preferred shares. If the issuer suspends dividends, shareholders may still be
liable for income taxes on the unpaid dividends. TruPS - Trust Preferred
Securities are Smith Barney's brand name for Trust Preferreds.
TOPrS - Trust Originated Preferred Securities are Merrill Lynch's
brand name for Trust Preferreds.
Yield to Call: return you would receive assuming the preferred is
redeemed on the call date.
Yield to Maturity: return you would receive assuming the
preferred is redeemed on its maturity date.
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