Understanding Preferred Stocks: A Guide To Alternative Dividend Investing

Preferred stocks are a type of investment that is gaining popularity among people who want a steady source of income and the benefits of owning stocks. They are a unique blend of fixed-income and equity features, making them an attractive option for certain investors. This article will delve into what preferred stocks are, how they work, how to purchase and sell them, what companies issue them and provide examples of their use.

What are Preferred Stocks

Preferred stocks represent ownership in a company, just like common stocks. Still, they are a different class of stock with distinct characteristics. The main difference between preferred and common stocks is that preferred stocks usually have a fixed dividend rate, meaning that the amount of dividends paid remains the same over time. Common stocks, on the other hand, do not have a fixed dividend rate. Instead, the payment of the dividends may fluctuate based on the Company earnings. On the other hand, common stocks have the chance of increasing in value, while preferred stocks do not.

How do Preferred Stocks Work

Preferred stocks work by having a fixed dividend rate, which means that the Company must pay a fixed amount of dividends to the preferred shareholders before paying any dividends to the common shareholders. This distinction makes preferred stocks similar to bonds, which also pay a fixed interest rate. In the event of bankruptcy, preferred shareholders have a higher claim on the Company's assets and earnings than common shareholders. However, it's important to note that if the Company goes bankrupt, there is a possibility that preferred shareholders may not be paid at all. Therefore, it is crucial to review a company's creditworthiness before investing in it’s preferred stocks.

Preferred stocks can also have other features, such as callable or convertible features. Callable preferred stocks allow the Company to redeem your shares at a specific price after a specified date. Callable means that your preferred stock and steady source of income are at risk of being repurchased from the Company they were issued. As a result, callable preferred stocks typically yield higher dividends than convertible preferred stocks, as investors need incentives such as higher earning potential when taking on more risk.

Example: Let's say you bought from Company A 10 callable preferred stocks for $20 each, with a yearly dividend rate of 5%. From Company A, you would receive a steady income stream for your investment. However, Company A also has the right to buy back your shares after two years at the same price you paid for them, $20 per share.

After one year, Company A decides to issue more shares with a lower dividend rate of 4.25%. They don't want to pay you a higher dividend rate than necessary, so they choose to exercise their right to buy back your shares after two years. As a result, you lose your preferred shares and the steady income stream they provide.

Conversely, convertible preferred stocks allow shareholders to convert their shares into common shares after a specific date at a certain price. That said, when the market value of common shares increases, the market value of convertible preferred shares will typically follow. Additionally, suppose you were to convert your preferred stock into common stock. In that case, there's a potential for capital gains earnings depending on the difference between your initial investment and the worth of your converted common stock shares. 

Example: You invest in Company A by buying 100 shares of convertible preferred stock for $100 each. The conversion ratio is 2, meaning for every 1 share of preferred stock, you can receive 2 common stocks. With 100 shares at $100 each, you have a total initial investment of $10,000. Suppose you convert your shares when the common stock price is $50. In that case, you will break even because you would receive 200 common shares, which, when sold at $50 each, would equal your initial investment of $10,000.

However, if the common stock price rises to $60 per share due to the Company experiencing a bull run, your 200 common shares would be worth $12,000. As a result, your initial investment of $10,000 would now have a potential profit of $2,000 ($12,000 - $10,000).

How to Purchase and Sell Preferred Stocks

Investors can go through a broker to purchase and sell preferred stocks, similar to common stocks. You can either buy the shares at the market price or place an order to purchase the shares at a specific price. You can also sell the shares at any time, either at the market price or a specific price. As an investor, you should be aware of the risks involved in investing in preferred stocks. While preferred stocks are generally considered less risky than common stocks, they still carry risks that you should be aware of, like interest rate and credit risk. Interest rate risk refers to the risk that the value of the preferred stock will decline if interest rates rise. On the other hand, credit risk is the risk that the Company defaults on its dividend payments or goes bankrupt, causing investors to lose out on their investment.

What Type of Companies Issue Preferred Stocks

Preferred stocks are often issued by companies with a stable financial position and a consistent stream of earnings. These companies may be in industries such as utilities, telecommunications, or real estate investment trusts (REITs).

Some companies that have issued preferred shares include:

● Coca-Cola

● Bank of America

● Verizon 

● Ford

● Microsoft

Preferred Stock Use

Preferred stocks are a versatile investment tool that can be used to achieve a variety of investment goals for investors. One of the primary benefits of preferred stocks is the steady and reliable source of income they produce, making them an ideal investment for anyone looking to generate revenue from their investments.

For instance, an investor may purchase preferred stocks to gain access to dividend income. Upon purchase, investors are provided with a stable source of income that is often considerably less volatile than other types of investments, such as common stocks or mutual funds. Preferred stocks can be particularly appealing for retirees or anyone who wants to generate income from their investments without taking on excessive risk.

Investors can also use preferred stocks to diversify an investment portfolio. Because they offer a unique blend of fixed income and equity features, preferred stocks can provide a way to balance the risk and return of a portfolio. For example, an investor who wants exposure to the equity markets but is concerned about the volatility of common stocks may choose to invest in a mix of preferred stocks and bonds to achieve a more balanced portfolio. Additionally, someone wanting to take on more risk and expand their income potential may balance their portfolio with a mixture of preferred and common stock. Although preferred stock does not boast the creditworthiness associated with U.S. bonds, strong and creditworthy companies can issue preferred shares that rival bonds when considering income and default possibilities.

Overall, preferred stocks offer a wide range of benefits to investors. Whether you're a retiree looking for a reliable source of income or an investor looking to diversify your portfolio, preferred stocks can provide a valuable addition to your investment strategy. By carefully evaluating potential investments and understanding the risks involved, investors can use preferred stocks to achieve their investment goals and build a diversified portfolio.