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About Preferreds
What You Need to Know Before Buying
Preferred Stocks
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What Are Preferreds?
Corporations issue preferred stock to raise cash. Thus, although you buy
or sell them the same way you trade regular common stocks, preferred
stocks are more like bonds than common stocks. Investors buy them for
the steady dividends, which typically equate to 4% to 8% yields. Most
preferreds pay dividends quarterly.
Unlike common stocks, you’re won’t enjoy much share price appreciation
if your company comes up with a hot product. Further, in most cases, the
dividend never goes up either.
Interest Rates Control Share Prices
Prevailing interest rates are the most important factor controlling
preferred share prices. If market rates rise, preferred prices will
probably drop, and vice versa. Here’s why.
Suppose that you own preferreds paying an initial 6% dividend yield. For
instance a preferred issued at $25 that pays dividends totaling $1.50
annually. Now, say that prevailing corporate rates rise to 7%. There
would be no market for preferreds paying 6% at $25 per share. Instead,
buyers would only be willing pay $21.43 per share. At that price, the
$1.50 annual dividend would equate to a 7% return ($1.50 divided by
$21.43 is 7%).
Conversely, if interest rates drop, investors would be willing to pay
more for you shares because they are yielding better than market
returns. Thus, the best time to own preferreds is when you think that
interest rates headed down.
Companies that issue preferred shares typically sell more than one
series, for instance, Series A, Series B, etc. Ticker symbols are
usually the issuing firm’s ticker followed by a “-“ and then the series
identifier. For example, the ticker for Bank of America’s “I” series
preferreds is “BAC-I”. MSN Money’s (moneycentral,msn.com)
Company Report is the best place to see current prices and trading
volumes.
Preferred?
The term “preferred” means that a firm must pay the dividends due on its
preferred shares before it pays any common stock dividends.
Also, in theory, if a company goes bankrupt, preferred holders have
priority over common stock shareholders. However, when a company fails,
both common and preferred shareholders usually get nothing.
Finally, another meaningless distinction: unlike common stock holders,
preferred shareholders don’t get to vote on company proposals. But, in
fact, individual common shareholders have almost no influence on any
corporations’ policies.
Nuts & Bolts
When a company issues preferred shares, it sets the annual dividend and
sells the shares at a preset price, typically $25, but some are issued
at $50 or $100.
The initial yield, called the “coupon rate,” is the annual dividend
divided by the issue price. For instance, the yield on shares paying
$1/year on shares issued at $25 is 4%.
However, since preferred shares trade on the open market just like
regular stocks, the actual trading price depends on supply and demand.
Thus, if the shares mentioned above slip to $24, the yield to new
investors (market yield) rises to 4.2% ($1 divided by $24).
Calling Preferreds
Preferreds have minimum 30-year maturities and some are perpetual,
meaning that the firm is not obligated to redeem them. However, most
preferred shares are “callable,” meaning that the issuer has the right
to call (redeem) them at the “call price” after a specified date (call
date), typically five-years after issue. The call price is the original
issue price.
However, the issuer is not obligated to redeem the shares at the call
date. Issuers are likely to call their preferreds if interest rates have
dropped and they can save money by calling existing preferreds and
selling a new batch paying lower rates. Thus, depending on prevailing
interest rates, preferreds might continue to trade for years after the
call date.
Buy Below Call Price
For preferreds near, or already past their call dates, it’s important to
buy shares trading below the call price. That way, you make money if
they are called. For instance, suppose that you buy shares trading at
$23 with a $25 call price. Excluding dividends collected, you would
enjoy close to a 9% capital gain. Conversely, you would lose 7% if you
paid $27 for shares that were called at $25.
That would not be an issue if the shares were non-callable, or if the
call date is years away.
Credit Ratings
Bond rating agencies such as Moody’s and Standard & Poor's analyze the
financial strength of issuing corporations and rate their preferreds
using a combination of letters, numbers, and plus or minus signs such as
AAA, BA1 or B-.
The details vary between agencies, but any rating starting with A, and
three letter ratings starting with B, indicates investment quality.
Here are the symbols S&P uses to indicate investment quality ratings,
starting with the highest quality: AAA, AA, A, and BBB. Here are S&P’s
'below investment grade' ratings, again listed from best to worst: BB,
B, CCC, CC, C and D. S&P often adds a “+” or “-“ to a rating to indicate
that it falls near the top or bottom of a rating category.
Here are the symbols that Moody’s uses to indicate investment quality
ratings, starting with the highest quality: Aaa, Aa, A, and Baa. Here
are Moody’s 'below investment grade' ratings listed from best to worst:
Ba, B, Caa, Ca, and C. Moody’s often adds a “1,” “2,” or “3” to a rating
to indicate that it falls near the top or bottom of a rating category (1
is best).
Since issuers must pay Moody’s or S&P to be rated, not all preferreds
are rated. It’s best to stick with preferreds rated investment quality.
That said, unrated preferreds aren’t necessarily risky, but they require
more work since you’ll have to do the financial strength analysis on
your own.
Beware; bond-analysts sometimes overlook the obvious. For instance, a
couple of years ago, many didn’t realize that falling home prices would
reduce the value of mortgages secured by those homes. Thus, it’s up to
you to keep up with the news and avoid industries with obvious problems.
Tax Issues
For reasons too involved to detail here, the dividends from some
preferreds are subject to the maximum 15% dividend tax rate, while
others are taxed as ordinary income. That can make a big difference. For
instance, $1.00 of dividends taxed at 15% nets out to roughly the same
amount as $1.30 taxed at the maximum 35% ordinary tax rate.
Also, for corporations that have invested in other firm’s preferred
shares, sometimes the dividends received are taxable, and sometimes not.
Quantum Online (www.quantumonline.com)
specifies whether the 15% maximum rate applies, and the dividend tax
status for corporations, for each issue.
Trading Volumes
Some preferred shares are not widely followed and are lightly traded.
Those are risky business because the lack of trading volume makes it
difficult to move in or out of a position at a reasonable price. Avoid
preferred stocks trading less than 10,000 shares daily, on average.
Evaluating Preferreds
Evaluate preferreds by analyzing the issuing company’s financial
strength. What’s important is that the firm has the cash to pay its
dividends. It doesn’t matter if the issuer’s earnings came in below
analysts’ estimates or it said next quarter sales would be lower than
previously forecast.
Here
are some selection criteria to keep in mind.
•
Current Price vs. Call Price: current price should be no higher than
call price, and preferably lower.
•
Credit Rating: must be investment grade (any rating starting with "A"
and three-letter "B" ratings.
•
Trading Volume: 10,000 shares, on average, traded daily.
•
Issuing Company Analyst Consensus Buy/Sell Rating: hold or better.
•
Issuing Company Return on Assets: 12% or higher.
•
Issuing Company TTM Operating Cash Flow: positive.
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Preferred Stocks Glossary
Adjustable Rate: annual dividend varies depending on predefined
factors.
Callable: issuer has the right to redeem shares at issue price
after a specified date.
Call Date: earliest date that shares can be called. Usually five
years after issue date.
Call Price: price issuer will pay for redeemed shares. Usually
the same as the issue price.
Convertible: holders have the right to convert preferred shares
to common stock at predetermined ratio after specified date. This gives
preferred holders a chance to benefit from the common stock’s share
price appreciation.
Coupon Rate: yield based on initial issue price
Cumulative: skipped dividends must still be paid before common
stock dividends are paid and before the shares are redeemed.
Current Yield: yield based on current share price.
CUSIP: unique identifier for each security.
Ex-Dividend Date: you must purchase shares prior to the
ex-dividend date to receive the corresponding payout.
Issue Price: original share price.
Liquidation Value: same as issue price.
Market Yield: same as current yield.
Maturity Date: the date the preferred shares must be redeemed by
the issuing firm, typically 30 to 100 years after issue.
Par Value: same a issue price
Participating: annual dividend varies depending on firm’s net
income or dividends paid to common shareholders.
Redeemable: same as “callable.”
Redemption Date: same as call date.
Third Party Trust Preferred: a Trust Preferred issue by a third
party such as an underwriter.
Trust Preferred: a bond that has been packaged to trade like a
preferred stock.
Yield to Call: return you would receive assuming the preferred is
redeemed on the call date. |
