Preferred shares are a hybrid between regular stock, usually called common stock, and corporate bonds. While any company can issue them, companies in the financial sector, such as banks, are more likely to offer preferred shares. At times, the entire class of preferred shares in banking companies is referred to as preferred bank shares. Investing in preferred bank shares involves two decisions: whether or not you should buy preferred shares and whether investing in the financial sector is right for you.
Understanding Preferred Shares
Preferred shares sit between bonds and common stock. Like bonds, they usually pay regular interest. Frequently, their yields are relatively high, making them a more profitable place to put your money than bonds. Preferred shares usually don't come with voting rights, which makes them like bonds. Like stock, though, they trade on investment markets and their prices can fluctuate. The company also has the opportunity to cancel the dividend on preferred stock if it wishes, just as it can cancel common stock dividends.
Preferred Share Benefits
The key benefit of preferred shares is the return they offer. When you invest in preferred stock, you get higher cash flow than you would with some other cash-flowing investments. You also may get the secondary benefit of convertibility. Some preferred shares can be turned into regular common stock, letting you get the benefit of traditional stock ownership. Since preferred shares are traded on public markets, they are also liquid, meaning you can pull your money out of them by selling them.
Preferred Share Risks
While preferred shares might pay returns that make them look like bonds, they aren't bonds. If a company gets into trouble and goes bankrupt, you don't get your money back until all of the bondholders are paid off. While canceling an interest payment on a bond is a default, it isn't with a preferred share. In addition, since preferred shares trade based on their returns, they also expose you to interest rate risk. When rates go up, preferred shares go down. When interest rates are low, this can be a real risk.
The Financial Sector
Investing in preferred shares issued by banks means that you're putting your money in the hands of the financial sector, which tends to be cyclical: When the economy does well, it does well, and when the economy does poorly, it does poorly. While preferred shares should enjoy some insulation from the stock market as a whole, they can suffer more in tough markets. As an example, the Standard and Poor's 500 stock index dropped 46 percent between July 2008 and March 2009, but preferred stocks fell by 63 percent. This is largely because so many of them were tied to the banking industry, which was particularly damaged in that downturn.
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