Are preferred stocks your best choice?

The yields look interesting, but this asset class has its share of drawbacks.

Adam Zoll 12 August, 2013 | 6:00PM

Question: I notice that the yields on preferred stock are substantially higher than those that common stocks pay out, as well as most bonds. How do preferred shares of stock work, and what are the risks I should consider?

Answer: Preferred stock is a form of equity that carries many of the features of a bond, but with some key differences, which we'll get to in a moment. As you note in your question, the primary appeal of preferred stock for investors, especially those looking for alternatives to the low yields offered by many fixed-income vehicles these days, is that they tend to provide higher yields than bonds.

In fact, the   iShares S&P/TSX CDN Preferred Common ETF  CPD currently carries a yield of 4.56%. By comparison, the   BMO Aggregate Bond Index ETF  ZAG, which tracks a broad sampling of the Canadian investment-grade bond market, offers a yield of just 3.42%, and the S&P/TSX 60 currently has a dividend yield of about 2.94%.

Preferreds' extra yield might sound like just what the doctor ordered for yield-starved investors, but naturally it comes at a price. Before we explore further, let's examine the pros and cons of preferred stock.

The pros
Yield, of course: As we've already mentioned, preferreds tend to offer higher yields than bonds. Unlike common stock, in which the dividend can vary based on company earnings, preferreds' dividends usually are fixed, meaning that investors have a good sense of what the yield will be.

Ahead of common stock in the pecking order: Preferred stock falls behind bonds and ahead of common stock in the capital structure, meaning that, while not considered a company obligation in the same sense that income payments to bondholders are, preferred share dividends take precedent over common share dividends when a company allocates its income. Preferred share dividends might be deferred, however, if the company runs into trouble.

Tax treatment: Dividends from Canadian preferred stock benefit from the same favourable tax treatment as common stock dividend, whereas income from bonds and bond funds is taxed at your full marginal income tax rate.

So far so good, right? But as we'll see, preferreds carry their share of minuses, as well.

The cons

Callable: Some preferreds have very long maturities of 20 years or more, while others have no maturity dates at all. Many also have provisions that allow the issuer to call in the shares (typically five or more years after shares were issued and at par, or the issuing price). That means that if interest rates decline the issuer may decide to buy back the existing preferred shares in order to issue new ones at a lower rate. On the flip side, if rates go up, the holder of the preferred shares might be left holding a security that pays less than the market rate for many years or in perpetuity, effectively reducing the value of the holding.

No tangible benefit from company growth: Unlike common shares, which might appreciate as company earnings rise, preferred shares generally offer a fixed dividend, meaning that any company growth has minimal effect on the preferred share price. If the company goes into a tailspin, however, that preferred stock dividend could be threatened, hurting its share price.

Tend to be issued by heavily leveraged companies: Among the most common issuers of preferreds are financial-services, telecom and utility companies, who use preferred stock as a tax-advantaged way to increase their borrowing power. Of course, this approach can lead to trouble for companies that borrow more than their balance sheets can handle, especially during economic downturns. Also, investors seeking to build a portfolio of preferreds to generate income are likely to encounter diversification problems because the market is dominated by preferred stocks from banks and other financial companies.

As you can see, the higher yield and tax advantages of preferreds is offset by the callability, interest-rate and other risk factors that come along for the ride. That isn't to say they don't have any merit as a potential source of extra yield for income investors. But moving ahead with eyes wide open and being well aware of factors shaping the market is essential.

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About Author

Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com