Preferred stock represents an interesting investment option that lies between common stock and bonds. It offers investors a unique set of features, including a fixed dividend rate, priority in dividend payments and asset distribution over common stockholders, and in some cases, the potential for capital appreciation. For companies, issuing preferred stock can be an attractive way to raise capital without diluting the ownership and control of existing common shareholders as much as issuing additional common stock would. In this comprehensive guide, we will explore the various aspects of how to get preferred stock, from understanding the different types available to the methods of acquisition and the factors to consider before investing.
Understanding Preferred Stock
Key Characteristics
Dividend Preference
Preferred stockholders have a higher claim to a company’s earnings compared to common stockholders. The company is obligated to pay dividends to preferred stockholders before any dividends are distributed to common stockholders. These dividends are usually fixed and expressed as a percentage of the par value of the preferred stock. For example, if a company issues preferred stock with a par value of $100 and a dividend rate of 5%, the annual dividend per share would be $5. This fixed dividend provides a relatively stable income stream for investors, making preferred stock an appealing option for those seeking regular income.
Priority in Liquidation
In the event of a company’s liquidation or bankruptcy, preferred stockholders have a higher priority in claiming the company’s assets compared to common stockholders. They are entitled to receive the par value of their shares, plus any unpaid dividends, before common stockholders receive anything. This priority position offers a certain level of protection to preferred stockholders, although it’s important to note that in many cases, bondholders and other creditors will have an even higher claim on the company’s assets.
Lack of Voting Rights (in most cases)
Unlike common stockholders, who typically have the right to vote on important corporate matters such as the election of the board of directors and major corporate decisions, preferred stockholders usually do not have voting rights. However, there are some exceptions. In certain situations, such as when the company fails to pay dividends for a specified period or if there are proposed changes to the rights of preferred stockholders, they may be granted voting rights. This limited voting power means that preferred stockholders have less influence over the company’s day-to-day operations and strategic decisions compared to common stockholders.
Types of Preferred Stock
Cumulative Preferred Stock
Cumulative preferred stock is designed to protect investors from missed dividend payments. If a company is unable to pay the full dividend amount in a given period, the unpaid dividends accumulate and must be paid in full before any dividends can be paid to common stockholders. For example, if a company fails to pay the $5 dividend on its cumulative preferred stock for two years, it will owe $10 per share in dividends to preferred stockholders before it can resume paying dividends to common stockholders. This feature provides an added layer of security for investors, ensuring that they will eventually receive their full dividend entitlement even if the company experiences temporary financial difficulties.
Non-Cumulative Preferred Stock
In contrast, non-cumulative preferred stock does not accumulate unpaid dividends. If the company fails to pay the dividend in a particular period, the right to that dividend is forfeited. For example, if a company misses a dividend payment on its non-cumulative preferred stock, it is not obligated to make up that missed payment in the future. This type of preferred stock is generally considered riskier than cumulative preferred stock, as investors may not receive their expected dividend income if the company’s financial situation deteriorates.
Convertible Preferred Stock
Convertible preferred stock gives investors the option to convert their shares into a predetermined number of common shares at a specified conversion ratio. This feature can be attractive if the company’s common stock price rises significantly, as it allows preferred stockholders to participate in the potential capital appreciation of the company. For example, if a convertible preferred stock has a conversion ratio of 2:1 and the common stock price increases, the preferred stockholder can convert their shares and potentially benefit from the increase in the common stock’s value. However, if the common stock price does not perform well, the investor can still hold the preferred stock and receive its fixed dividend payments.
Callable Preferred Stock
Callable preferred stock gives the issuing company the right to redeem the shares at a predetermined price after a certain date. This is often done when interest rates in the market decline, allowing the company to refinance its capital at a lower cost. For example, if a company issued callable preferred stock with a call price of $105 per share and interest rates have dropped, it may choose to call the shares and issue new preferred stock with a lower dividend rate. From the investor’s perspective, while callable preferred stock may offer a higher initial dividend rate to compensate for the call risk, there is a possibility that the shares will be called away before the investor.
Why Invest in Preferred Stock?
Income Generation
Stable Dividend Payments
As mentioned earlier, the fixed dividend rate of preferred stock provides a reliable income stream. This can be particularly appealing for retirees or income-focused investors who rely on regular dividend payments to cover living expenses or supplement their other sources of income. For example, an investor who holds a significant amount of preferred stock with a total par value of $100,000 and a dividend rate of 4% would receive $4,000 in annual dividend income. This income is relatively stable compared to the potentially more volatile dividends of common stock, which can be cut or eliminated by the company depending on its financial performance.
Higher Yield Than Bonds (in some cases)
In certain market conditions, preferred stock may offer a higher yield compared to bonds. This is especially true for lower-rated or riskier preferred stocks, which compensate investors with a higher dividend rate for the additional risk. For example, a corporate bond with a similar credit rating might offer a yield of 3%, while a preferred stock from the same company could offer a yield of 4.5%. However, it’s important to note that this higher yield comes with increased risk, as preferred stockholders are junior to bondholders in the event of a company’s financial distress.
Potential for Capital Appreciation
Company Growth and Performance
If the issuing company performs well and its common stock price increases, convertible preferred stockholders have the opportunity to benefit from capital appreciation. As the value of the common stock rises, the conversion option becomes more valuable, potentially increasing the market price of the convertible preferred stock. For example, if a company’s common stock price doubles, and the convertible preferred stock has a favorable conversion ratio, the value of the preferred stock could also increase significantly. This allows investors to participate in the company’s growth to some extent while still enjoying the fixed income and priority features of preferred stock.
Interest Rate Movements
Preferred stock prices can also be affected by changes in interest rates. When interest rates decline, the fixed dividend payments of preferred stock become more attractive, leading to an increase in demand and potentially a rise in the stock’s price. Conversely, when interest rates rise, the value of preferred stock may decline as investors seek higher-yielding alternatives. For example, if the Federal Reserve lowers interest rates, investors may flock to preferred stocks, driving up their prices. This inverse relationship between interest rates and preferred stock prices provides an opportunity for investors to profit from changes in the interest rate environment.
Diversification Benefits
Asset Class Diversification
Adding preferred stock to an investment portfolio can provide diversification benefits. Preferred stock has characteristics that are different from both common stock and bonds. It offers a middle ground in terms of risk and return, with a relatively stable income stream like bonds but also some potential for capital appreciation like common stock. By including preferred stock in a portfolio that already contains stocks and bonds, investors can reduce the overall risk and potentially improve the risk-adjusted return. For example, during a period when the stock market is volatile and bond yields are low, preferred stock may provide a more stable performance, helping to balance the portfolio.
Sector Diversification
Preferred stocks are issued by companies in various sectors, including financials, utilities, telecommunications, and energy. By investing in preferred stock from different sectors, investors can further diversify their portfolios and reduce the impact of sector-specific risks. For instance, if an investor holds preferred stocks from both a utility company and a technology company, the performance of the portfolio may be less affected by a downturn in the technology sector, as the utility preferred stock may provide more stability.
How to Get Preferred Stock
Through a Brokerage Account
Research and Selection
The first step is to research and identify the preferred stocks that meet your investment criteria. This involves looking at factors such as the company’s financial health, its dividend history and stability, the credit rating of the preferred stock (if available), and the terms and features of the stock, such as whether it is cumulative, convertible, or callable. You can use financial news websites, stock screeners provided by brokerage firms, and research reports from analysts to gather information. For example, if you’re interested in investing in preferred stock for income, you might focus on companies with a strong track record of paying dividends and a stable business model. Once you have identified the preferred stocks you want to invest in, you can place an order through your brokerage account.
Order Placement
Most brokerage accounts offer a simple process for buying and selling preferred stock. You can place a market order, which will execute the trade at the current market price, or a limit order, which allows you to specify the maximum price you’re willing to pay for the stock. For example, if the current market price of a preferred stock is $50 per share, and you’re comfortable paying up to $51, you can place a limit order at $51. The brokerage will then attempt to fill your order at or below that price. It’s important to note that the liquidity of preferred stocks can vary, so it may take some time for your order to be filled, especially if you’re placing a limit order.
Participating in a Preferred Stock Offering
Initial Public Offerings (IPOs)
When a company decides to go public and issue preferred stock for the first time, it conducts an IPO. To participate in a preferred stock IPO, you typically need to work with a brokerage firm that has access to the offering. The brokerage may require you to have a certain account balance or meet other eligibility criteria. You will need to express your interest in the offering during the IPO subscription period. The allocation of shares in an IPO is often oversubscribed, meaning there are more investors interested in buying the shares than there are shares available. As a result, the allocation process may be competitive, and you may not receive the full number of shares you requested. For example, if you apply for 1,000 shares in a preferred stock IPO and the offering is oversubscribed, you may only be allocated 200 shares.
Secondary Offerings
Companies may also issue additional preferred stock in secondary offerings to raise more capital. These offerings can be either public or private. In a public secondary offering, the process is similar to an IPO, where investors can participate through their brokerage accounts. In a private secondary offering, the shares are typically sold to institutional investors or accredited investors. Accredited investors are individuals or entities that meet certain income or net worth requirements. If you’re an accredited investor, you may have the opportunity to participate in private secondary offerings, which can sometimes offer more favorable terms or access to exclusive investment opportunities. However, these offerings also carry higher risks and require a more in-depth understanding of the investment and the issuing company.
Direct Investment with the Company
Contacting the Company
In some cases, it may be possible to invest in preferred stock directly with the issuing company. This is more common for smaller, privately held companies or in certain specialized situations. To do this, you would need to contact the company’s investor relations department or its corporate secretary. You can usually find the contact information on the company’s website. Explain your interest in investing in their preferred stock and ask about the process and any requirements. For example, a local utility company that is looking to raise capital through preferred stock issuance may be open to direct investment from local investors. The company may provide you with the necessary forms and information to complete the investment.
Meeting the Requirements
The company may have specific requirements for direct investors. This could include a minimum investment amount, which could be relatively high compared to buying shares through a brokerage account. For example, a company might require a minimum investment of $50,000 in its preferred stock. You may also need to provide certain financial information and demonstrate your ability to meet the investment commitment. Additionally, the company may have restrictions on the transferability of the shares, meaning you may not be able to sell them easily in the secondary market. It’s important to fully understand these requirements and implications before proceeding with a direct investment.
Factors to Consider Before Investing in Preferred Stock
Company Financial Health
Earnings and Revenue Stability
Before investing in a company’s preferred stock, it’s crucial to assess its financial stability. Look at the company’s earnings and revenue trends over the past several years. A company with consistent and growing earnings and revenues is more likely to be able to meet its dividend obligations and maintain the value of its preferred stock. For example, a well-established utility company with a steady customer base and regulated revenue streams may be more likely to pay its preferred dividends regularly compared to a start-up in a highly competitive and volatile industry. Analyze the company’s financial statements, including the income statement and balance sheet, to understand its profitability, debt levels, and liquidity.
Debt Burden and Solvency
Examine the company’s debt levels and its ability to service its debt. A company with a high debt burden may face difficulties in paying dividends if it has to allocate a significant portion of its earnings to debt repayment. Look at ratios such as the debt-to-equity ratio and the interest coverage ratio. A high debt-to-equity ratio indicates that the company has a relatively large amount of debt compared to its equity, which could increase its financial risk. The interest coverage ratio shows how easily the company can pay the interest on its debt. A low interest coverage ratio may suggest that the company is at risk of defaulting on its debt payments, which could have a negative impact on its preferred stockholders.
Interest Rate Environment
Impact on Preferred Stock Prices
As mentioned earlier, preferred stock prices are inversely related to interest rates. When interest rates rise, the value of existing preferred stocks with fixed dividend rates tends to decline, as investors can find higher-yielding alternatives in the market. Conversely, when interest rates fall, preferred stocks become more attractive, and their prices may increase. For example, if you invest in a preferred stock with a 4% dividend rate and interest rates in the market rise to 5%, the market price of your preferred stock is likely to decrease. It’s important to consider the current interest rate environment and the potential direction of interest rate changes when investing in preferred stock. If you expect interest rates to rise, you may want to be cautious about investing in long-term preferred stocks, as their prices could be more sensitive to rate increases.
Yield Comparison
Compare the yield on the preferred stock you’re considering with other investment options, such as bonds and savings accounts. In a low-interest-rate environment, the yield on preferred stock may seem attractive, but it’s important to factor in the additional risks associated with preferred stock, such as the lack of guaranteed principal repayment and the junior position to bondholders in the event of a company’s financial distress. For example, if a 10-year Treasury bond is yielding 2% and a preferred stock is yielding 4%, the higher yield on the preferred stock may be tempting. However, you need to consider the credit risk of the company issuing the preferred stock and the potential for changes in the preferred stock’s price.
Liquidity
Trading Volume and Bid-Ask Spreads
The liquidity of a preferred stock refers to how easily it can be bought and sold in the market. Preferred stocks with higher trading volumes are generally more liquid, meaning you can execute trades more quickly and at a more favorable price. Check the average daily trading volume of the preferred stock you’re interested in. A low trading volume may result in wider bid-ask spreads, which is the difference between the price at which buyers are willing to buy (the bid) and the price at which sellers are willing to sell (the ask). A wide bid-ask spread can increase the cost of trading and reduce the potential returns. For example, if the bid price for a preferred stock is $49 and the ask price is $51, the bid-ask spread is $2. If you buy and sell the stock, you effectively lose $2 per share in addition to any other trading costs.
Market Conditions and Volatility
Market conditions can also affect the liquidity of preferred stock. During periods of market stress or volatility, the liquidity of all securities, including preferred stock, may decline. Investors may become more risk-averse and less willing to trade, leading to lower trading volumes and wider bid-ask spreads. For example, during a financial crisis, the liquidity of many preferred stocks dried up, making it difficult for investors to sell their shares at a reasonable price. It’s important to be aware of the potential impact of market conditions on the liquidity of your preferred stock investments and to have a long-term investment horizon to ride out any short-term liquidity issues.
Conclusion
Investing in preferred stock can be a valuable addition to an investment portfolio, offering a combination of income generation, potential capital appreciation, and diversification benefits. However, it’s important to understand the various types of preferred stock, the methods of acquiring them, and the factors to consider before making an investment decision. By conducting thorough research, assessing the financial health of the issuing company, considering the interest rate environment and liquidity, and working with a reputable brokerage or exploring other investment channels, investors can make informed choices and potentially benefit from the unique characteristics of preferred stock. As with any investment, it’s essential to have a clear investment strategy and to monitor your investments regularly to ensure they continue to meet your financial goals and risk tolerance.
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