Would preferred stock be a safe harbor?
Holly Nicholson, Correspondent
Q: I'm sure I'm not alone in the pursuit of a safe place to invest.
I've heard that shares of preferred stock might be a good solution. I've never purchased these, but they sound like the best of both worlds – the upside of the stock but with a higher dividend and the security of a bond.
Could you explain how this type of stock works and let me know whether you think this is a good time to buy preferred stock?
A: Preferred shares offer some safety features not found in common stock shares, but they are not as safe as bonds.
If a company declares bankruptcy, preferred shares are senior to common stock but bonds have more seniority than preferred shares. Seniority determines the order in which creditors are repaid before other creditors receive payment.
Bondholders are repaid first, and it is rare that they are made completely whole, leaving nothing for less-senior creditors.
Similar to bonds, the direction of interest rates has an effect on preferred share values. Preferred shares are issued at a fixed par value, and the dividend paid is based on a percentage of that par at a fixed rate.
If interest rates rise, the value of the preferred shares will drop. If interest rates decline, the value of the shares will increase. If you think interest rates are poised to rise, you might want to stay away from preferred shares.
Unlike bonds, preferred shares rarely have a maturity date. Bonds will have a maturity date, so you know that if you hold the bond, you will receive the stated interest and at maturity you will be repaid your principal. Even if the value of your bond goes down because of changes in prevailing interest rates, unless the company declares bankruptcy, you will have your principal returned.
Because preferred shares have no fixed maturity date, you don't have this return of principal feature. Some preferred shares will have a callability feature, allowing them to be called by the issuing company. The company will only call the shares if they are paying a higher rate than similar preferred shares. This would have negative effect on your portfolio, because you would no longer receive the high dividend, and if you paid a premium (a price higher than the par value when issued) for the shares, you would experience a loss.
Most preferred shares can be converted to common stock of the issuing company. This gives you the opportunity, after a predetermined time or a specific date, to profit from a rise in the share price.
If the stock price doesn't rise, you can keep your preferred shares and enjoy the dividend. The dividend is declared by the company's board of directors.
Bond interest is paid first, then preferred dividends are paid from the companies after-tax profits. If a company is having cash problems, it can decide to withhold preferred share dividends. Most preferred shares are cumulative, which means any dividends withheld are considered in arrears and must be paid before any other dividends. Preferred stock that doesn't have this feature is called straight or non-cumulative.
It would be wise to review your entire portfolio with an objective investment adviser before adding preferred stocks to help determine whether they are a good fit.
Holly Nicholson is a financial planner in Raleigh. Reach her at www.askholly.com or P.O. Box 99466, Raleigh, NC 27624. She cannot answer every question.