Preferred Stocks Deliver High Yields
Investors seeking income may want to look at preferred stocks as a source of high dividend yields. Typically the yield on preferreds can be several percentage points higher than yields of comparable income securities. But before you buy a preferred, get educated about them because preferred stocks come in many flavors.
Preferred stocks are issued by the same companies that offer everyday common stock. The yield on a preferred stock is considerably higher than the yield on a common stock.
Preferred stocks offer a dividend that never increases and the price of the preferred stock usually stays in a narrow range unlike common stock that can shoot up or fall precipitously. So owners of a preferred stock will miss out on large upside moves associated with the common stocks of the same company.
The benefits of preferred stock include:
- High dividend yield - usually higher than common stock dividends and bond yields of comparable risk.
- Receive dividends ahead of common stock holders so preferreds have a better chance of receiving dividends if the company experiences financial problems.
- Price is much less volatile than the price of common stock.
The drawbacks of preferred stock include:
- Limited upside price appreciation. Preferreds do not track the price of the common stock one for one so owners of preferreds can miss out on a large price upside.
- Price varies inversely with interest rates. So the price of a preferred can be less than the price you paid.
- No maturity date like a bond so you are not guaranteed to recover your principal at a given date.
- Some preferreds can be redeemed (called) by the issuer if interest rates fall so your income flow from the preferred stock would stop.
Preferred stocks have some features like a stock and others like a bond. Here is list of important features to look for in a preferred stock:
- Cumulative, pays all past due accumulated dividends if dividends were stopped for a period and then resumed. But preferred dividends are paid after bond payments.
- Noncumulative, does not pay all past due accumulated dividends if dividends were stopped.
- Callable, issuer may require you to redeem the preferred stock at a given price - usually if interest rates drop.
- Not callable, issuer will not redeem the preferred stock.
- Convertible, is exchangeable for a given number of common stocks on a given date. Holders may be forced to convert share to common stock. The price of a convertible preferred is more volatile than the price of a non convertible
- Non convertible, is not exchangeable for a given number of common stocks.
Also check with your tax consultant about the tax treatment of income received from preferred stocks. Some income is taxed at 15 percent while other income is taxed at higher rates.
How to Buy Preferred Stocks
You have three choices to own preferred stocks:
- Individual preferred stocks
- Closed-end funds
- Open-end funds
- Exchange-traded funds (ETFs)
Individual Preferred Stocks
You can buy shares of individual preferred stocks through a broker just like you buy common stock. You'll pay a commission when you buy and sell the stock. If you buy individual preferreds, you should buy preferreds for more than one company to spread your risk among several stocks. Like any asset it is prudent to diversify your holdings.
QuatumOnline give price quotes and much more information about preferred stocks. The site is free but you must register to obtain quotes.
You can buy closed-end funds that specialize in preferred stocks. The funds holds many preferred stocks so you have some safety through diversification. Closed-end funds are traded on major stock exchanges and you purchase a closed-end fund through a broker and pay a commission.
A closed-end fund deducts its management fees before it distributes the dividends, so your dividends will be reduced by the size of the fees. As with any mutual fund, buy closed-end funds that charge the lowest fees. Closed-end funds trade at either a discount or a premium to their underlying net asset value. Only buy a closed-end fund when it is at a discount.
The last option is to own regular (open-ended) mutual funds that concentrate on preferred stocks. Many of these funds have high fees and should be avoided.
Exchange-traded Funds (ETFs)
You can buy ETFs that specialize in preferred stocks.