Why preferred stocks aren't a great compromise

When someone refers to the stock of a company, you immediately think about common stock. Owning them gives you an ownership share of a firm, you get voting rights, sometimes you’ll get dividends and you hope that it will increase in price. When someone talks about bonds, you think of safe securities with regular but somewhat low yields. These are the two extremes of the investing spectrum: Risky assets with high potential return and safe assets with a low but steady return. But there is a compromise: preferred shares. To understand them we have to take a closer look at stocks and bonds.

Common stocks and Bonds: The basics

A common stock refers to an ownership share of a firm. Owning this asset gives you voting rights and entitles you to a percentage of the income of the firm. This can be paid by reinvesting equity into the firm or by paying it out in dividends. Common stocks are senior to bonds, which means that, if the firm goes bankrupt, the needs of bondholders are prioritised. Owning stocks can be beneficial because of the dividend, a regular payment that the firm gives you, or if there is none, the capital gains that you receive when the common stock appreciates in value. It is riskier than a bond, because if a firm isn’t doing well or is merely perceived badly, the effects can be felt quickly in the share price and even its inability to pay dividends.

Bonds, on the other hand, have no stake in the firm. They are a debt obligation, issued by the firm. For bonds, firms pay a regular yield until the bond matures, which is when the principal payment, the amount that you paid for the bond (provided you bought it directly from the firm) is repaid. Issuers make a strong contractual obligation to bondholders, giving the asset an extra layer of safety. They are senior to both types of stocks: Common and preferred. Bonds prices and yields have an inverse relationship: When yields rise, prices fall on the secondary market and vice versa. (The secondary market is the market where traders buy and sell assets after they have been issued.) Bond yields tend to rise with the yields of government bonds and general interest rates. Bonds can be callable by the firm, but they don’t have to be. They can also be converted into common stock, sometimes.

What are preferred stocks

Preferred stocks are, in many ways, a hybrid investment, as they combine elements of both bonds and stocks. Let’s look at the similarities and differences

Similarities and differences with stocks

Preferred stocks also represent an ownership share of a company and like some stocks, you get regular dividends.

These dividends are higher, though and you do not get voting rights in the company. Preferred stocks are also callable (forceful buybacks) when it is advantageous to the issuer (I’ll get into this later) and they are more secure than common stocks when it comes to volatility. Their seniority is also higher than that of a common stock. Price fluctuations are not quite as severe as those of a common stock. From the viewpoint of the equity investor, this asset acts like a debt instrument, because of low price fluctuations and consistent dividend payments. This goes hand in hand with the nature of bonds.

Similarities and differences with bonds

Preferred stocks, like a bond, get regular payments, are issued at a par value and act like a debt obligation. Bonds are sometimes callable as well. Like bonds, an inverse relationship between the share’s price and yield exists on the market for senior shares. They are also rated by an agency.

However, this rating is pretty much always lower than the bond of the same company and. From the viewpoint of bondholders, preferred shares act more like equity than debt. They have no maturity, unlike bonds but rather a date from which point onward they can (but, importantly, don’t have to be) called. They have a junior claim on assets, compared with bonds, meaning that the needs of bondholders take precedence over the needs of the senior shareholders. Contractually, bonds are also bound closer to the firm than preferred shares, making preferred shares a riskier investment. Importantly, the income that preferred shareholders get is called a “dividend”, while bondholders get a yield. This difference is due to the option of firms to omit a dividend payment when they are not able to do so (In cumulative preferred stocks, the neglected dividend is repaid in the next payment). This makes senior shares look like equity to bondholders. The tax benefit for preferred stocks is not as great as with bonds for firms, so it makes more sense for firms to issue bonds than to issue preferred shares.

Overview: What is a preferred stock

To sum up: Preferred stocks entitle the investor to a share in the company with no voting rights. Price fluctuations are low and the main source of income for investors is the higher and regular dividend. Dividends can be omitted in many cases and preferred shares have a call date, on and after which the firm has the right to forcefully buy them back (This price is close to par value but, typically, a small premium is paid as compensation for diminishing any potential profits). This is advantageous to the firm because of the inverse bond-like relationship between a shares price and dividend yield. When dividend yields get low, shares are bought back and new shares with a lower yield are issued, since those were the ones available on the market anyway. While preferred stocks are safer in terms of price fluctuations than stocks, that also makes them extremely illiquid, which means that finding a buyer can take days or even weeks. They do not have maturity date and are junior to bonds but senior to common stocks. They do not have the same strong contractual relationship that bonds have, which makes them look like equity from bondholders. They do not produce great capital gains, which also makes them look like a debt instrument to junior shareholders, because they are also rated by a ratings agency, which, by the way, gives them a lower rating than bonds.

Looking at the description I gave, it seems that preferred stocks are a compromise between stocks and bonds, but many good qualities are also omitted. It makes you wonder whether they are such a good compromise after all…

Preferred stocks – the worst of both worlds

“The worst of both worlds”, is a term that has been used often when dealing with preferred stocks and for good reason: Their ambiguous investment class with a clear lack of security for a lack of great capital gains has made them a questionable investment which has been criticised by many investors like, most notably, Benjamin Graham.

Benjamin Graham’s viewpoint

Benjamin Graham is known for his popular investment philosophy and his 2 most popular books: “the Intelligent Investor” and “Security Analysis”. It was his belief that the investment form of the preferred stock was fundamentally and inherently flawed and that they should only be bought, when:

· Its legal position bound it so close to the company that it was worth investing in, giving it a favourable quality, which bonds possessed.

· It could be acquired in a state where its price was below that of the intrinsic value of the senior share, or in other words, if it was undervalued. This advice, especially, is unsurprising when you consider Graham’s investing philosophy: Value investing – One ought to buy assets below their intrinsic value and sell them when the price has reached it or, even better, exceeded it.

“Only a small percentage of all preferred issues are so strongly entrenched as to maintain an unquestioned investment status through all vicissitudes. Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity. […] In other words, they should be bought on a bargain basis or not at all.” – Benjamin Graham in the Intelligent Investor

Preferred stocks – pros and cons

Pros:

• They offer steady and high dividends

• Their prices are not as volatile as those of common stocks

• They take precedence over common stocks

• (They can have tax benefits for institutions, but this probably doesn’t apply to most readers, so I put it in brackets)

Cons:

• Bonds take precedence over senior stocks

  • They thus have the 2nd claim on assets, making their position more unfavourable than that of bonds when the firm suffers financially

• They are unable to generate high capital gains

• They are a lot less safe than bonds

  • Note the lacking contractual agreements

• Dividends can be omitted, when you’re not dealing with cumulative stocks, meaning that even the little income that you were promised at higher risk might not even be paid

• They are usually called / forcefully bought back when the asset is beneficial for the investor, destroying potential profits

• Conversely, they can never be called. They have no date of maturity, so when the firm has no reason to call the asset, you might be stuck with a senior share forever, since…

• They are extremely illiquid and finding a buyer might entail having to give up profits

• Fixed dividends can be badly affected by inflation, especially when you hold them longer and now: a period of high inflation

The cons clearly triumph over the pros, which is why Graham and many others dislike this asset so much. As Graham stated before, senior shares of a firm can be acquired if increased security is provided or when it is undervalued. Another thing that has to be specified here is the call risk.

Call risk

This was already mentioned above, but this is a more specified version: When a firm issues preferred stock, it has to pay a specified dividend. Omitting them when they’re doing well financially, would be a bad look, but the firm doesn’t want to pay high dividends, so they’ll start looking for shortcuts. When dividend rates decline on the market and prices rise, firms might use the call date on senior shares to forcefully buy them back on a predetermined price, which is oftentimes lower than the market price (close to par value, plus a small premium, to compensate for the cap on potential profits). They then issue new stock at a lower rate, which is the rate the market was at anyway. To new potential investors, this move is insignificant and even in their favour, because they’ll be paying a lower price for the same yield on (most likely) the same par value. For existing senior shareholders, it destroys potential profits on the market. On the other hand, if rates rise, the firm will do nothing, since issuing new shares at the same par value for a higher yield, or the market yield, wouldn’t be advantageous to them. For investors, selling them entails doing so at a lower price. This is worsened by the illiquidity of preferred stock, driving potential profits down even more.

Preferred stocks and inflation

So, how does extremely high inflation change the way that preferred stocks work and the way that they can be used? Buying during inflation entails allowing other assets to immediately become more popular due to rising rates. Don’t even think about waiting and then selling them, because the market will react like the bond market: Rates will rise and prices will fall. Other assets will gain more traction, leaving you and your asset behind. Of course, less support from the government regarding interest rates and bond buying problems could also cause firms to miss payments. Also, keep in mind that inflation eats away at steady returns. And any hope of companies calling the assets is gone, since they’re getting less support from the Federal reserve and yields are getting higher and higher. Where a normal economic environment made preferred stocks a questionable investment already, inflation makes them useless.

Conclusion

So, are preferred stocks worth it? Probably not. At least, not now. If you buy them now, inflation will ruin many benefits they might have had. Maybe you could make it work somehow - maybe you could find the one exceptional senior share that everyone has been missing. That’s really hard to do though. If inflation does pass, buying preferred stocks would be far more advantageous, since the prices would be low and the yields would be sky high – in accordance with Graham’s philosophy. Still, be weary of them. Any company issuing this asset type with such a high yield, which is importantly not tax deferred for them, instead of bonds might not be in good health.