Recently, while I was taking a letter to our mailbox, I met two of our neighbors who were out for a midmorning walk. After exchanging pleasantries, one of the neighbors asked my thoughts regarding preferred stocks as an investment. After a short discussion of preferred stocks, they continued their walk and I returned to my house. Later, I reflected on the question and the ensuing conversation and concluded that a short series of articles on preferred stocks would be of interest to the readers of my monthly column. So here goes!
Preferred stocks have features of both bonds and common stocks. Examples of shared features with preferred stocks and common stocks follow: 1. Preferred stocks trade on stock exchanges, such as the New York Stock Exchange and the American Stock Exchange. 2. Preferred stocks represent ownership or equity, not debt. 3. Preferred stocks sometimes have voting rights.
Features preferred stocks share with bonds include: 1. Preferred stocks pay a fixed interest rate. 2. Preferred stocks have a “par value.” For example, they are issued in par value denominations of $25, $50 and $100. The interest rate is based on these values. 3. Preferred stocks may be issued with a “call,” “cumulative” or “convertible” provisions. These three provisions will be discussed in my next article. 4. Preferred stocks pay interest while common stocks pay dividends.
Since preferred stocks pay a fixed interest rate based on their par values, the market price of preferred stocks is generally more stable than the market price of common stocks. For example, a $25 par value preferred stock that pays a 10 percent interest rate will pay the shareholder $2.50 annually, or more likely $.625 quarterly. This payout remains fixed for the lifetime of the stock. The interest payment of preferred stocks must be paid in full when due. Partial or reduced payments are not allowed. On the other hand, the dividend of a common stock may or may not exist or the amount of the dividend may vary from quarter to quarter at the discretion of the company. If the earnings increase, the dividend may increase and if the earnings decrease, the dividend may decrease or be eliminated. The bottom line is: The market price of preferred stocks is generally more stable than the market price of common stocks.
In the case of bankruptcy, the owners of preferred stocks are ahead of the owners of common stocks, regarding settlement payouts. However, both owners are the last to receive any payouts. As you might expect, the federal and state governments, along with pension deficiencies, bond holders, and creditors, for example, are ahead of them.
Is there a better time to buy or not to buy preferred stocks? Yes, I believe there is. For example, when the overall market interest rates increase, existing preferred stock prices as well as bond prices decrease. Why? The companies issuing fixed interest rate investments may not adjust the interest rates of these investments. Therefore, the market prices of these investments rise and fall to bring the market interest rate of these investments in line with the overall market interest rate. The bottom line is: The overall market interest rate and the market price of fixed interest rate investments move in opposite directions. As one increses, the other decreases.
To illustrate, consider the following hypothetical example: A $25 preferred stock with a 10 percet interest rate, selling at par ($25). Assume the prevailing market interest rate is also 10 percemt. Suppose the prevailing market interest rate increases to 11 percent. Would investors be inclined to buy a preferred stock paying 10 percent when they can purchase investments in the market place paying 11 percent? I think not. So what happens to the market price of the preferred stock? The market price of the preferred stock begins to decrease from $25, and approaches $22.72, where the market interest rate is 11 percent. Remember, the 10 percent is a fixed interest rate based on a $25 par value and it may not be changed.
Next time, I will discuss the three provisions: “call,” “cumulative” and “convertible” that may be attached to preferred stocks.
Upon request, my October Activity Report and September 2017 semiannual “High Yield Stocks” Report are available. These investments are not recommendations. They are investment ideas that must be researched by each investor to determine their suitability.
Burt Hiester is a Times-News columnist. His email address is firstname.lastname@example.org.