1. Money
You can opt-out at any time. Please refer to our privacy policy for contact information.

Preferred Shares of Stock Not Your Best Choice

Bonds Offer Most of the Same Advantages With Less Risk

By

Preferred stock may or may not be a preferred investment for you, but don't let the name fool you - these securities have less going for them than it appears.

Preferred stock is a special class of stock that some companies issue in addition to common stock. However, the attraction of preferreds, as they are called, are the dividends they pay.

The name implies something special about preferred shares and they do have some special rights and features. However, for some of the reasons you buy stock, preferred shares don't work.

Preferred stock is a hybrid security that is a fixed income investment rather than an investment for appreciation.

Dividends

The shares typically pay a fixed rate dividend, much like a corporate bond (they are rated by the major credit agencies).

Preferred stock has a preferential claim over common stock on dividend payments and assets of the corporation in the event of liquidation. The preferred dividend must be paid before the common stock dividend and the shares have a higher claim on assets then common shares in the event of a liquidation or bankruptcy.

Corporate bonds are senior to preferreds, meaning in a liquidation they have higher claim on assets. The general hierarchy of claims on a company's assets in a bankruptcy is: bonds, preferred stock, common stock.

The interest rate for preferreds is fixed, however the board of directors has the right to withhold dividend payments if the company is in a cash bind. The company may not withhold dividend payments on its bonds without going into default, which means senior creditors (bondholders) can force the company into bankruptcy.

You may find that preferred stock that has the same rating from the credit agencies as a bond may pay a slightly higher dividend.

Preferred stock holders have no vote in corporate matters and the price does not appreciate as common stock does.

Preferred stock is usually bought by institutions that can avoid much of the taxes on dividends thanks to a handy IRS rule.

Preferred stock, like bonds, is interest rate sensitive. If interest rates go up, preferred shareholders may have to take a lower price if they want to sell. Bonds are in the same situation. This article explains the relationship between bonds and interest rates. The same basic relationship applies to preferred stock and interest rates.

Benefits

Individuals can own and benefit from preferred stock, but you must be very careful because not all shares are equal.

Many preferred shares are callable, meaning if market interest rates drop, the company can call the shares. You will receive your money (preferred stock is bought at par) back, but will have to reinvest at lower prevailing rates.

In addition, preferred shares may carry different restrictions and qualifications that vary from company to company.

Before you buy preferred stock, have a competent tax advisor tell you if the shares' dividends qualify for the 15 percent dividend tax treatment or will they be considered ordinary income. How the preferred shares are structured will make a difference.

Reasons

It is hard to come up with a good reason for individuals to own preferred stock. Bonds work better, although they have some drawbacks also, as a fixed income investment because the income is guaranteed by the bond's indenture.

The dividends for preferred stock must be authorized by the board of directors who can suspend them if cash is tight (preferred dividend are paid out of after tax funds, while interest on bonds is paid before taxes).

Conclusion

If you thoroughly understand a particular preferred stock and it works for you, go for it. However, I wouldn't spend much time studying preferred stock otherwise. There are too many other options (high quality bonds, money market accounts and so on) that are far less complicated.

©2014 About.com. All rights reserved.