What is a preferred stock? (Part1)

A preferred stock is a way for a company to raise money, like bonds or common stock.  I think the best way to define preferred stock is to look at the differences between preferred stock, bonds and common stock.  This post will concentrate on comparing common stock and preferred stock.  I will attempt to tackle bonds later.

Preferred stock vs common stock.

Both preferred stock and common stock represent ownership in a company.  Common stock stockholders have a vote at the yearly stockholder meeting, but preferred stockholders have no vote.  Having a vote is not of much value unless you own a significant percentage of the outstanding common shares.  I am guessing that most of my readers are not investing a million or more dollars in a single stock, so voting rights are not much of a right.  Preferred stocks do have an advantage in the payment of dividends.  A company has to suspend paying dividends on the common stock if they want to stop paying dividends on the preferred stock.  It is possible that the company has preferred stock and it does not pay dividends on their common stock.  In that case a company may still have a commitment to pay the preferred stock dividends.  Preferred stock dividends are either cumulative or non-cumulative.  With cumulative dividends the company can stop paying the dividends but if it resumes it has to pay those dividends that it missed.  With non-cumulative dividends, as you may guess, the company does not have to pay any dividends it missed.  Although preferred stocks with cumulative dividends may seem better than those that are not, you also have to look at the company issuing the stock.  For example, JP Morgan Chase recently issued preferred stock with non-cumulative dividends.  They are a very solid company, less likely than others to stop paying the dividend.

Preferred stock dividends are usually fixed or in rare instances tied to an interest rate like Libor.  Common stock dividends can and often change. If we look at a comparison between the common and preferred shares of JP Morgan stock, we can see the difference. The JP Morgan class C preferred shares trading at about 26.3 per share have a dividend yield of about 5.7% in May of 2019.  Eight years from now if they are not redeemed, they will have about the same yield and price.  The common stock in May of 2019 has a dividend yield of 2.94% on the $109 stock.  If you go back to July of 2011 the common shares of JP Morgan were selling at $42 a share with a dividend yield at that time of 2.38%.  If you had purchased the JP Morgan stock back then, you would have a 159% increase in the value and the dividend based on your 2011 price would be 7.62%.  Of course, it is easy to go back in time and find examples like that.  It is equally easy to find examples where the stock price fell and the dividend was cut.  So, if you are looking for consistent higher yield now, then the preferred stock is the better option.

As mentioned in my previous article, qualified preferred stock dividends have the same tax treatment as capital gains.  Common stock dividends, again if they are qualified dividends, have that same tax treatment.  You have to own the stock for a certain period of time before they get this tax treatment for both preferred and common stock.

Preferred stock can be rated by an agency like Standard and Poor’s.  These are similar to the ratings that bonds get.  The rating is an indication of the company’s ability to pay the dividend into the future.  The ratings from Standard and Poor’s range from AAA to C.  More about this when we get to the comparison with bonds.  Common stock is not rated in this way, instead the analysts rate the common stock on how they feel the value of the stock will increase in the future.  Common stock gets a rating like buy, hold or sell.

To recap, Common stocks have voting rights and preferred stocks do not.  Dividends will have to be paid on all the preferred stock before a company can pay dividends on common stock.  Preferred stock dividends stay the same where common stock dividends can go up or down.  The tax treatment for common and preferred dividends is the same assuming they are both qualified and you meet the ownership requirements.   Common and preferred stock are rated differently.  If you are looking for current income preferred stock is better, for growth common stock is better.

Starting with Preferred Stocks

I was new to Preferred Stock Investing over two years ago and would like to share my experiences and my mistakes.  I had just retired at 56 with my wife and we hoped to live on our after tax money until we could or would have to tap into our tax sheltered accounts. In the current relatively low interest rate environment, I was looking for a way to generate income with a better return than tax free bonds with some tax advantage.  Preferred Stocks seemed to have the same tax advantage as capital gains.  If your income is below a certain limit the dividends from Preferred Stocks can be tax free.  At the very least, dividends from certain preferred stocks have a lower tax rate than normal income.  For corporate bonds on the other hand, the interest is taxed at the same rate as normal income.  It seemed to me that preferred stocks were a better option with good returns and lower to no taxes on those returns.

I started looking for preferred stocks to invest.  I searched the internet and found various lists including one on my broker's site.  Wanting to make as much as possible I looked for companies I knew that were paying a good return.  I purchased several of these and started doing more research on dividends and taxes.  This is where I found my first mistake.

To be treated the same as capital gains, dividends from preferred stocks have to be qualified dividends.  These are from normal domestic corporations not Limited Partnerships (LP) or Real Estate Investment Trusts (REIT).  I had bought preferred stock from a Limited Partnership so I ended up selling those shares at or about the same price I paid for them, wasting my time and money.  So if you are buying preferred stock for the tax advantage be sure it has fully qualified dividends.

Let's talk price and its impact on return.  Most preferred stock is sold with a redemption price of $25 per share.  Some are sold at $50, $100 or even $1000 a share but those are exceptions.  Let's stick with $25 stocks for this discussion.  The price you pay is set by the market.  For a preferred stock that has been around for some time the price may be higher than $25 or possibly lower than $25.  An example would be BANK OF AMERICA CORPORATION 6% Preferred Series EE.  At a price of $26.20 per share, it is $1.20 above the redemption price.  It pays 6% a year in qualified dividends on the $25 redemption price.  This is $1.50 per year.  If we divide this by the current price we get a return of  5.723% a year.   Bank of America could redeem these shares at $25 on 4/25/2021.   It is possible that you would only receive 2 years of dividends before they redeem the stock.  If we take the $0.60  (1.20/2) from the yearly dividend, then you may only receive 90 cents a share. This figure takes the loss at redemption into account.  90 cents divided by the purchase price of $26.20 would yield  3.44% return.  Bank of America may or may not redeem the stock in 2021, so the longer they wait before redeeming the shares the real return starts to approach the 5.723% rate.  This brings me to my second mistake of not looking at the possible redemption date.

I purchased a preferred stock at around $26 a share and less than a year later it was redeemed.  The dividends I was paid almost made up the difference between the redemption price of $25 and the price I paid.  Again, it was a waste of time and money.  Be careful what you pay for a preferred stock in relation to its current return and the impact of a possible redemption.

I plan to update this blog once a month or more with more information on investing in preferred stocks so look back in the future.