Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

Preferred stocks under scrutiny: The good and the bad

When a firm issues equity on a public exchange, it has two primary options.  Generally, firms issue common stock (also known as ordinary shares), which is subordinated1 equity with voting rights, and is the type of stock that comprises the majority of public equity markets.  However, firms also have the ability to issue preferred shares, which is equity with characteristics of both stocks and fixed income, and for this reason is known as a “hybrid” security.

Preferred stock tends to be issued either with a long maturity date (e.g. 30-50 years), or with no maturity date, and a fixed dividend.  Both the dividend and the residual claim on equity (in case of bankruptcy) provided by the preferred share have a higher priority than those of common stock, making them more secure in the case of bankruptcy of the issuing firm.  In exchange for this increased security, preferred shares generally lack voting rights.  Also, while preferred stock has a senior claim on firm assets to common stock, it is subordinate to any debt (such as bonds) issued by the firm.  Finally, preferred shares often include a call provision, meaning that the issuing firm may buy back the stock at a pre-specified price at any point.

Preferred Stock Certificate

Thus preferred shares exhibit properties of both common stocks and bonds.  Preferred stock is issued a credit rating like other debt securities.  Also, because preferred shares pay a fixed dividend, they are subject to interest rate risk like any other fixed income security.  This can be problematic for holders of preferred shares, because the call provision subjects the securities to asymmetric (one-sided) risk.  If market interest rates increase, the value of the fixed dividend will decline, causing the shares to lose value.  However, if interest rates decrease, firms have the ability to call the preferred shares, and reissue them at lower interest rates.  This effectively limits the possible gain to shareholders as a result of changing interest rates without mitigating any of the related risk.  Similarly, preferred shares are exposed to asymmetric credit risk; as ratings decrease, the shares will lose value, but as ratings increase firms have an incentive to call the shares and reissue the debt at a lower cost.

Along with the one-sided interest rate risk, preferred stocks also retain some of the negative aspects of common stock.  While preferred shares have a higher claim on firm assets than common stock, they are still junior relative to all debt issuance, including convertible bonds and mezzanine debt.  As with common equity, they are also not guaranteed a dividend (though the dividend on preferred shares must be paid in full before any dividends can be paid on common stock).  This means that if the issuing firm experiences financial troubles, they are not necessarily obligated to pay the dividends on their equity.

The preceding analysis describes a security that suffers from both equity and fixed income risk, with limited potential for gains.  This may beg the question of why these shares exist.  If preferred stock is purchased by a corporate holder, they are able to claim a tax benefit on dividends received, but this tax advantage is not extended to individuals.  From an individual investor’s perspective, the benefit is less clear.  Preferred shares tend to have a fairly high yield, which is attractive to investors who desire high levels of current income.  Also, due to the hybrid properties of preferred securities, they do provide some diversification benefits when combined in a portfolio with common equity and fixed income.  Unfortunately, even accessing these securities in an efficient manner can be costly.  Most preferred stock funds are active, and these index funds often carry relatively high costs due to the esoteric nature of the securities.  Although preferred stock may be an asset class that can add value to a well-diversified portfolio in the future, at this point our evaluation is that they are an investment vehicle that carries too much risk relative to the potential benefits.

References
1. Subordinate or “junior” securities are those which do not have a primary claim on firm assets in the event of a default.  For example, if a firm issues bonds and stock, the stock is subordinate to the bonds, meaning that if the issuing firm goes bankrupt, the bondholders must be completely paid off before any money can be paid to stock owners.

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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