Preferred stock can be an especially worthy addition to your investment portfolio if you desire a steady and relatively reliable income stream. Preferred shares provide a far more secure, predictable dividend yield than common stock but are easier and cheaper to buy and sell than bonds. However, you should study the fine print and the potential call provision of preferred shares before you invest in them.
Preferred Stock Basics
Preferred stock is more of a borrowing instrument than a regular share and entitles the holder to periodic cash payments, known as preferred dividends. While dividend payments on common stock are entirely at the discretion of the board of directors and are therefore variable, preferred dividends are contractually fixed. These dividends resemble the periodic interest payments you receive when you deposit money in a bank. The board of directors, however, has the authority to indefinitely suspend payments to preferred stockholders in case of a cash crunch. Preferred stockholders cannot take legal action in such situations (such as a supplier could if it doesn't receive the money it is owed by the same firm).
Preferred shares can carry a call provision, giving the issuing firm the right, but not the obligation, to take back the preferred shares from their holders in exchange for a specific amount of cash. Such shares are known as callable preferred stock. Call provisions usually kick in several years after issuance. A preferred stock issued in 2012 may be callable starting in 2015, for example. Should the firm decide to call preferred shares, an announcement will be made and all holders notified through their brokers. You will usually have to do nothing at all and will merely see the preferred stock in your account vanish, to be replaced by cash.
When the issuer calls a preferred stock, the stockholder usually receives a premium over the original issue price. If, for example, the stock was issued at $100 per share and pays $7 per year in dividends, the call price may be $105. The $5 extra the issuer must pay over the issue price is referred to as the call premium. A call of the preferred shares will therefore result in windfall profits for shareholders. After collecting dividends for a few years, you may be compensated yet again over and above your original purchase price. Usually, the longer the firm waits before calling the preferred shares, the higher the call premium. While the call price stated in the legally binding prospectus issued along with the shares may be $105 in 2015, it may drop to $102 after 2018.
Despite providing a steady income stream and potential premiums in case of a recall, preferred stock also has certain disadvantages. First, most preferred shares do not give their holders voting rights in the annual shareholder meeting. Secondly, preferred shareholders can only receive money in case of a bankruptcy after all lenders have been paid in full. In most cases, preferred stockholders do not recover their full investment if the company goes out of business. Finally, the firm can suspend preferred dividends for a long time — a decade in some instances. Whether such suspension carries penalties for the issuer depends on the prospectus, which you must study in detail.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.