Do you have preferred status?

Bill Parrott |

Who doesn’t like a preferred status?  It’s nice to be preferred when boarding an airplane, entering a movie theater or getting a table in a crowded restaurant.  Preferred status carries a certain level of prestige.

One investment that carries the preferred moniker is the preferred stock.

Preferred stocks may help you generate greater income.  A preferred stock falls between corporate bonds and common stock on a corporate balance sheet.   Preferred stock holders must be paid their dividend first before a company pays the common stock holder their dividend.

Preferred stocks are interesting investments.  They are issued at $25 per share and pay a quarterly dividend.  The investments are non-callable for five years and then they can be redeemed by the issuing corporation.  If the issue is not called after five years, it’s possible your investment may have a maturity date of 20, 30, 40 years or more.  You don’t have to hold your investment for multiple decades because you can sell your holding at any time.  If you decide to sell, you may get back more or less than your original investment.   After the non-call date a company can redeem your holding on any interest payment date.

With the recent rise in rates many preferred stocks have traded down in value giving new investors a nice entry point.   The rate rise has pushed the price of these investments below their offer price of $25.  Bank of America and Capital One currently have issues yielding over 6% while Wells Fargo, Southern California Edison and J.P. Morgan have yields north of 5%.  Several companies are paying 7%, 8%, 9% or more.  

Here is how a preferred stock works.   A company issues shares at $25 per share with a 6% dividend.  If you buy 1,000 shares at $25 your total cost will be $25,000.  The 6% dividend will generate $1,500 per year or $375 per quarter.  For five years, the company can’t redeem your shares.  At the end of the five year term the company can call in your shares.  If your shares are called, your $25,000 investment will be credited to your account.  If they don’t call your shares, you’ll continue to receive $1,500 for as long as you own your shares.   These investments trade on the stock exchanges so you can buy or sell these shares at any time.

What is the downside to owning these fixed income investments?   I believe there are two risks.  If rates rise, the value of your preferred stock will lose value.  A highly rated preferred stock may trade to a price of $18 or $19 from their offer price of $25 per share if interest rates climb. The other risk is related to longevity.  If your preferred stock is not redeemed after five years, it may turn into a long term holding.  A company that issued a preferred stock in a low interest rate environment has little incentive to redeem your shares in a rising rate environment.

Preferred stocks are more aggressive when compared to U.S. Treasuries, municipal or corporate bonds.  However, a small allocation to your account can help you generate above average income.  How much should you invest in this category?  I would suggest an allocation of 5% to 15% of your fixed income portfolio.  

As interest rates continue to bounce around it may pay to add a few of these preferred investments to your portfolio.

Probable impossibilities are to be preferred to improbable possibilities. Aristotle

Bill Parrott is the President and CEO of Parrott Wealth Management.

November 20, 2016

Note: Past performance is no guarantee of future performance.