Quick Take on Fixed Income
Q: What are the characteristics of preferred stocks?
A: Preferred stocks can be viewed as a hybrid of stocks and bonds. Preferred shareholders receive preference over common equity holders (hence the term “preferred”) for dividend payouts and in the event of a Chapter 11 bankruptcy filing. However, all debt holders would be paid before any payment would be made to the preferred shareholders. Unlike with shares of common stock, which may benefit from a company’s potential growth, the investment return on preferred stocks is usually a function of the stock price and/or the fixed dividend rate (although there are some variable preferred stocks). The following are other characteristics of preferred stocks:
Longer maturity: Preferred stocks are generally perpetual or long term. The historical evidence on fixed income investing shows that longer maturities have the poorest risk-reward characteristics — the lowest return for a given level of risk (with risk being defined as volatility, or standard deviation). Longer-term maturities with fixed yields do provide a hedge against deflationary environments. The problem with long-maturity preferred stocks is that the call feature negates the benefits of the longer maturity in a falling-rate environment. Thus, the holder does not benefit from a rise in price that would occur with a non-callable, fixed-rate security in a falling-rate environment.
Call risk: If rates rise, the price of the preferred stock will fall. However, if rates fall, the issuer could exercise the call feature to replace the preferred stock with an option that has a lower rate, has less-expensive conventional debt or perhaps is even equity. Investors get the risk of a long-duration product when rates rise, but the gains are limited. Having protection from calls is important to income-oriented investors because callable instruments present reinvestment risk, or the risk of having to reinvest the proceeds of a called investment at lower rates.
Cumulative vs. non-cumulative risk: Investors should be aware that in times of financial distress, preferred dividends could be deferred. It is also essential to understand that unless the preferred is a cumulative preferred, the company is not obligated to make up the missed dividends. Cumulative preferred stock must make up for missed dividends before declaring any dividends to common stockholders.
Other considerations: There are no low-cost index funds or passive funds to help investors diversify the credit risks of individual issuers. Buying individual issues involves trading costs, a lack of diversification and the need to regularly monitor credit ratings. Because of these factors, instead of purchasing preferred stocks, a better option is to use high-quality short- to intermediate-term bonds in order to provide both cash flow and diversification for the overall portfolio.
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