Preferred Stocks

Investment Snapshot

* Preferred stock yields can be three to four times greater than common stock yields.
* Preferred stocks bear a greater resemblance to bonds than common stocks.
* Not all preferred stock issues share the tax advantages of common stocks.
* Chesapeake Energy Corporation issued a mandatory convertible preferred stock offering with a dividend yield of 6.25 percent.

The Investment Snapshot shows that preferred stocks appeal to investors seeking current income because of their higher yields over common stocks. In order to share in the lower federal tax rates on dividends, investors need to make sure that the preferred issues they purchase qualify for the lower tax rates. Convertible preferred stock can earn shareholders capital appreciation should the price of the common stock of the company rise above the conversion price.

WHAT IS PREFERRED STOCK?

Preferred stock is classified on a balance sheet as equity, but it has many features that resemble debt securities. Equity is defined as capital invested in a company by its owners; debt is capital lent to the corporation, which must be repaid. Preferred stock is a hybrid type of security in that it has characteristics resembling both debt and equity. Generally, preferred stocks have a fixed dividend, but owners of preferred stock do not have voting rights. Although preferred stock is classified as equity, preferred stockholders do not have ownership interests in the company. The failure of a company to pay dividends to preferred stockholders does not result in bankruptcy, as it would with the default of interest on bonds. Instead, the company does not pay common stockholders any dividends until the preferred stockholders are paid their dividends. Unlike common stock, the dividend rate on preferred stock is usually fixed. It might be stated as a percentage of the par value of the preferred stock or as a fixed dollar amount. The par value is a stated value, and hence a preferred stock issue with $100 par value that has a dividend of 8 percent would pay a dividend of $8 per share (8 percent of $100).

In the event of bankruptcy, the claims of preferred stockholders are senior to the claims of common stockholders on the earnings and assets of a company. If a preferred stock issue has a call provision, it may be retired by the company.

REASONS TO INVEST IN PREFERRED STOCK

The fixed dividend of preferred stock appeals to investors who seek regular payments of income, but in exchange for regular income, preferred stocks do not experience large capital gains (or losses). The downside to a fixed dividend rate is that the price of preferred stock is sensitive to changes in market rates of interest similar to bonds. For example, if you buy preferred stock for $100 a share that pays a dividend of $4, and market rates of interest subsequently go up to 6 percent, there will be downside pressure on the price of this preferred stock issue. New investors will not want to buy this preferred stock for $100 when the dividend is only $4 (a return of 4 percent, 4/100) and new preferred stock issues return a higher yield. Prices of adjustable-rate preferred stock issues do not fluctuate as much as the prices of fixed-rate preferred stock issues with changes in interest rates. Thus preferred stock is appealing to investors if interest rates remain stable or decrease.

Another advantage to owning preferred stock is the changes to the tax code enacted in 2003. Dividends from preferred stock are taxed at favorable rates, 5 percent for taxpayers in the 15 percent or lower marginal tax brackets and 15 percent for all other taxpayers. However, not all preferred stock issues benefit from this favorable tax treatment. A majority of the preferred stock issues, namely, trust preferred stock issues, do not qualify for this favorable tax treatment These trust preferred stock issues are created by trusts that technically pay interest, and therefore, the payments are taxed at taxpayers’ marginal tax rates (can be as high as 35 percent).

KEY CONCEPTS
* What preferred stock is
* Reasons to invest in preferred stock
* Characteristics of preferred stock
* How to evaluate preferred stock
* Trust preferred stock derivatives

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