If you are like many income-oriented investors, prolonged periods of low interest rates may spur you to seek out investments that have the potential to deliver higher yields. In your quest for more attractive yields, preferred securities may pop up on your radar screen.
At first glance, preferred securities may seem like an appropriate investment for those who are primarily looking for income-producing investments. While these hybrid securities often deliver yields higher than those of common stock or corporate bonds, there is more to the story. Before you invest, you need to understand what makes preferred securities different from common stocks and other high-yield securities.
A peek under the hood
Preferred securities, which are sometimes referred to as "hybrids," combine the features and characteristics of both stocks and bonds. Corporations often issue multiple series of preferred securities and the specific features of each can vary significantly from one issue to another.
Like common stocks, preferred securities provide you with an ownership or debtor stake in a publicly traded company. The term "preferred" refers to the fact that these securities provide shareholders with priority status when it comes to dividend or interest payments, which typically pay out at rates higher than those of common share dividends or bonds. Unlike shares of common stock or bonds, preferred securities carry no voting rights.
In the event of a bankruptcy or other financial difficulties, preferred securities are generally senior to common stock in a company's capital structure, but subordinate to secured bonds. This means that preferred security shareholders normally receive income before any dividend payments to common stock shareholders are paid out. If a company were forced to reduce or suspend dividend payments, common stock dividends would be impacted before preferred dividends. Keep in mind, however, that preferred securities are subject to greater credit risk than secured bonds from the same issuer.
While preferred securities generally offer attractive yields, opportunities for capital appreciation are generally lower than those from shares of common stock. Shareholders forgo any common stock dividends and the potentially larger future capital appreciation associated with common stock. Though capital gains opportunities for preferred securities holders can occur during periods of declining interest rates and improved credit conditions, the majority of investment returns from preferred securities have historically come from their periodic income distributions. It's important to note that, unlike common shares, you typically do not have the option of reinvesting dividends into additional preferred shares.
Key features to consider before investing
No 2 preferred securities are alike, so take the time to read the fine print and determine whether a particular issue you may be considering aligns with your investment needs, risk tolerance, and goals. Some of the features to examine include:
Payment features
Preferred securities usually make payments in the form of either interest or dividends based on the par (face) value of the security on a monthly, quarterly, or semi-annual basis. Payments may be made at fixed, floating, or adjustable rates. Preferred security payments are contingent upon the financial health of the issuer and may also be dependent on conditions or events indicated in the security's offering documents. Some preferred securities allow the issuer to defer or simply skip payments.
Cumulative or non-cumulative dividends
In most cases, deferred or missed payments on cumulative preferred securities accumulate as obligations of the issuer, and must generally be paid out to holders of preferred securities before common shareholders can receive dividend payments. However, with non-cumulative preferred securities, missed payments do not accumulate as obligations of the issuer and shareholders are not entitled to receive missed payments.
Certain preferred securities have more complex payment terms. For example, some have a floating or adjustable rate of payment based upon a short- or long-term interest rate index, such as the 3-Month London Interbank Offered Rate (LIBOR). Others may begin with a fixed coupon and convert into a floating coupon at some specified date (often referred to as a fixed-to-floating coupon payment). Such variable or adjustable payment terms may make it difficult to know for certain what yield you can expect to earn.
Maturity date
Preferred securities may have a stated maturity date; however, many are perpetual and do not. Additionally, even if there is a stated maturity date, the issuer may have the option to extend that date one or more times.
Call features/early redemption
With or without a maturity date, many preferred securities have optional, mandatory, and/or conditional early redemption or call provisions that permit the issuer to redeem the securities prior to the stated maturity date (if there is one) or at other times (in the case of no stated maturity date). These types of features can make preferred securities less appropriate for investors who are looking for steady payments over longer periods of time.
Convertibility
Convertible preferred securities can typically be exchanged for a specified amount of a different security, often the common stock of the issuing company. Convertible preferred securities may combine the fixed income characteristic of bonds with the potential appreciation characteristics of stocks. There are often provisions attached to convertible preferred securities that place restrictions on when they can be converted. Additionally, because convertible preferred securities can typically be exchanged for shares of the issuer's stock, the value of these securities may be more volatile than other types of preferred securities.
Taxes
Not all income from preferred securities is taxed the same way. Different issues from the same issuer may be structured differently and have different tax consequences. Be sure to read the Taxation section of the preferred security's offering documents to understand how it may be taxed. Consult with your tax advisor for additional information on how the income from preferred securities may impact your tax situation.
Yield
Preferred securities may provide more attractive yields than securities that have seniority in payment priority. Higher yields compensate investors for the increased risk associated with a lower payment priority. Generally speaking, higher yields are a sign of potentially greater risk.
There are a variety of yield calculations that can be used when evaluating a preferred security. Current yield (also commonly referred to as "dividend yield") is a commonly used yield calculation for traditional preferred securities. To calculate current yield, divide the annual interest or dividend payment amount by the current market price of the security and multiply the result by 100. For example, a preferred security with a $25 par or face value with a fixed coupon rate of 6.5% pays an annual interest or dividend payment of $1.625. If the current market price of the security were $24.25, the current yield would be 6.701% ($1.625 divided by $24.25 times 100).
Yield to call, yield to maturity, and yield to worst are yield calculations more commonly used for preferred securities that are debt or have debt-like attributes. Yield to maturity is the rate of return anticipated if a security is held to maturity date. The calculation of yield to maturity takes into account the current market price, par value, coupon rate, and time to maturity. It assumes that all coupon payments are reinvested at the same rate.
Yield to call is the yield on a security assuming it will be redeemed by the issuer on a specified call date. The calculation of yield to call takes into account the current market price, call price, coupon rate, and the length of time to the call date. Yield to worst refers to the lowest potential yield anticipated on a security.
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