Preferred stocks (or preferred securities) are hybrid investments that share characteristics of both stocks and bonds. They can offer higher yields than many traditional fixed income investments, but they come with different risks.
Typically, coupon payments are made every three months, and those payments take precedence over dividends for common stockholders. Most of these investments trade on a stock exchange, so prices can be tracked throughout the day. Take a closer look at the benefits.
Preferred stocks (or preferred securities) are a type of investment that pays interest or dividends to investors before dividends are paid to common stockholders. Like bonds, preferred stocks usually pay a fixed coupon rate based on a set “par” value. These investments tend to have very long maturities—usually 30 years or longer—or no maturity at all, meaning they are perpetual. However, most preferred stocks are callable, which means the issuer can redeem them at a set price (usually par) before the stated maturity date. Like bonds, preferred stocks generally carry a credit rating from a recognized rating agency, and that rating tends to be a little lower than the issuing firm’s individual bond rating.
Why would Schwab recommend preferred stocks?
Preferred stocks are designed to provide a steady income through quarterly interest or dividend payments, and their yields tend to be higher than those of other traditional fixed income investments. Also, most preferred stocks are traded on a stock exchange, so there is greater price transparency.
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Take a closer look at the benefits.
Preferred stocks usually pay quarterly dividend or interest payments.
Senior to common stocks
Preferred stocks are senior to common stock in payment of interest or dividends, so they are paid out before payments are made to common stockholders.
Most preferred stocks are quoted and traded on a stock exchange, so their price is visible at all times and they can be tracked and traded throughout the day. However, depending on the size of the preferred stock issue, there can still be a large bid-ask spread when they are traded.
Stop orders can be used on exchange-traded preferred stocks to manage risk.
In addition to the risks commonly associated with fixed income securities, such as call, liquidity, reinvestment, inflation (or purchasing power), market, and event risks, the following risks should be considered when making decisions about preferred stocks:
Because preferred stocks are lower in the capital structure than bonds, the credit rating for preferred stocks is generally lower than that for the bonds the company issues. Therefore, preferred stocks have higher risk.
Interest rate fluctuation
Due to their long maturity dates (or lack of a maturity date in some cases), the prices of preferred stocks are generally very sensitive to changes in interest rates. If interest rates rise, preferred stock prices tend to fall.
No dividend guarantees
For many preferred stocks, a missed coupon payment doesn’t necessarily constitute a default. Unpaid coupon payments accrue to holders of cumulative preferred stocks, but they are lost with non-cumulative preferred stock. Before buying a preferred stock, always pay attention to the characteristics of the individual issue.
The risk that the value of a fixed income security will fall as a result of a change in interest rates. This risk can be reduced by diversifying the maturities of fixed income investments or investing in floating rate securities.
The risk that a security will default or that its credit rating will be downgraded, resulting in a decrease in value for the security. The measurement of credit risk usually takes into consideration the risk of default, credit downgrade, or change in credit spread.
The risk to bondholders that a call option will be exercised by the issuer at an unfavorable time for the holder, such as when interest rates are low. If you are a bondholder whose security is called, you can lose potential interest income.
The relative ability of a security to be sold without substantial transaction costs or reduction of value. The harder it is to sell a security or the greater the loss in value resulting from a sale, the greater the liquidity risk.
The risk that cash flows from an investment will be reinvested when interest rates are lower, resulting in a possible reduction in cash flow. To mitigate reinvestment risk, an investor can purchase non-callable bonds, which are not subject to early redemption and/or ladder bond maturities at different intervals over time.
Inflation (purchasing power)
The risk that inflation will erode the real return on investment. This occurs when prices rise at a higher rate than investment returns and, as a result, money buys less in the future. The risk is greatest if you’re investing over long periods of time.
Market and event
The risk that a change in the overall market environment or a specific occurrence such as a political incident will have a negative impact on the price/value of your investment.
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