Preferred stock is a form of equity that carries many of the features of a bond, but with some key differences. The primary appeal of preferred stock for investors, especially those looking for alternatives to the low yields offered by many fixed-income vehicles these days, is that they tend to provide higher yields than bonds. Preferreds' extra yield might sound like just what the doctor ordered for yield-starved investors but naturally it comes at a price. In a nutshell, a preferred stock is a half-bond, half-share investment, offering a fixed income and a dividend.
The Pros
Yield, of course: As we've already mentioned, preferreds tend to offer higher yields than bonds. Unlike common stock, in which the dividend can vary based on company earnings, preferreds' dividends usually are fixed, meaning that investors have a good sense of what the yield will be.
Ahead of common stock in the pecking order: Preferred stock falls behind bonds and ahead of common stock in the capital structure, meaning that, while not considered a company obligation in the same sense that income payments to bondholders are, preferred share dividends take precedent over common share dividends when a company allocates its income. Preferred share dividends might be deferred, however, if the company runs into trouble.
Tax treatment: As with ordinary shares, buyers of UK-listed preferred shares pay 0.5% stamp duty. The capital and income tax treatment is also the same as for shares, so they tend to be paid net of a 10% dividend tax credit.
ISA-eligibility: Most UK-listed preferred shares are eligible to be held in an ISA tax shelter or a self-invested personal pension (SIPP). (Read more on these wrappers in “The Difference Between ISAs and SIPPs”.)
The Cons
Callable: Some preferreds have very long maturities of 20 years or more, while others have no maturity dates at all. Many also have provisions that allow the issuer to call in the shares (typically five or more years after shares were issued and at par, or the issuing price). That means that if interest rates decline the issuer may decide to buy back the existing preferred shares in order to issue new ones at a lower rate. On the flip side, if rates go up, the holder of the preferred shares might be left holding a security that pays less than the market rate for many years or in perpetuity, effectively reducing the value of the holding.
No tangible benefit from company growth: Unlike ordinary shares, which might appreciate as company earnings rise, preferred shares generally offer a fixed dividend, meaning that any company growth has minimal effect on the preferred share price. If the company goes into a tailspin, however, that preferred stock dividend could be threatened, hurting its share price.
Tend to be issued by heavily leveraged companies: Among the most common issuers of preferreds are financial-services, telecom and utility companies, who use preferred stock as a tax-advantaged way to increase their borrowing power.
Of course, this approach can lead to trouble for companies that borrow more than their balance sheets can handle, especially during economic downturns. Also, investors seeking to build a portfolio of preferreds to generate income are likely to encounter diversification problems because the market is dominated by preferred stocks from banks and other financial companies. Aviva (AV.) and Standard Chartered (STAN) are two such examples.
The Bottom Line
As you can see, the higher yield and tax advantages of preferreds is offset by the callability, interest-rate and other risk factors that come along for the ride. And while some investors might be perfectly willing to take on these risks, there are additional complications to consider. Preferred shares carry multiple risks, not least of which is an uncertain future in light of new financial regulations, but that isn't to say they don't have any merit as a potential source of extra yield for income investors. Moving ahead with eyes wide open and well aware of factors shaping the market is essential.
