Mind on money: the devil’s in the details with ‘preferreds’

Mind on money: the devil’s in the details with ‘preferreds’
By: Marc Ruiz Last Updated: July 20, 2020

Some types of investment yield seem, for now, to be a thing of the past. The word “yield” in this conversation describes the practice of receiving an actual cash payment for an investment. Yield differs from capital appreciation, which is the strategy of buying an investment and hoping it goes up in value at some later time.

The more conservative and traditional types of investment vehicles which generate yield have been bank CDs, savings accounts and various types of bonds. The yield paid on all these types of financial instruments is almost universally below 3%, and with the more secure forms of investment, such as Treasury Bonds or bank CDs, receiving yields north of 1%, it is becoming more and more challenging.

In the search for yield, investors are having to search for alternatives, and one type of security still offering the potential to generate cash payments is preferred stocks, or "preferreds."

Preferreds are publicly traded securities and occupy a kind of hybrid spot in the universe of investments. These securities involve characteristics of both stocks and bonds, and in my experience can sometimes be confusing to investors attempting to evaluate them.

Preferreds are issued by many different types of companies. In my practice, however, when we use these investments, we tend to focus on ones issued by financial institutions and utilities.

Our reasoning behind focusing on these sectors is preferreds occupy what can be termed a junior position in the capital structure of a corporation, or, said more simply, if a company gets in deep financial trouble or declares bankruptcy there is a good chance preferreds holders will have entitlement to very little money (reorganization or liquidation proceeds).

By choosing preferreds issued by highly regulated banks, insurance companies or utilities, the thought process is the likelihood of financial difficulty may be reduced, but as we all know, no company is truly immune to financial hardship, so investors in preferreds must be willing to accept this potential risk.

Preferreds can also be complicated and involve features that lend advantage to the issuing company over the investors. Features such as the right to cash in the preferred prematurely, termed a call, or the right to skip cash payments to investors (dividends) if the company is stressed financially can be difficult to discern by reviewing easily available information. Sometimes a deeper dive or review of difficult to find original offering documents is required.

What makes preferreds attractive, of course, is the cash payments they offer to investors. These securities typically can offer predictable quarterly dividend rates, and a set “par” value that will be returned to the investor at a future maturity date or when called. Many preferreds issued by major U.S. banks are now yielding cash divided payments between 5% and 7%. These payments are declared, but not guaranteed.

While this certainly sounds attractive to investors seeking cash payments, it's important to remember preferreds trade like both stocks and bonds, meaning they will go up and down in value depending somewhat on the financial health of the issuing company, and they will also trade like bonds in that their prices will be directly impacted by changes in interest rates.

These two different influences can cause preferred prices to fluctuate considerably and so investors also need to be prepared for some price volatility as well.

Sadly, in our yield-starved world, I doubt bank CDs or Treasury bonds will provide attractive yields for perhaps a couple years. For investors seeking cash payments, preferred stocks can have a place in an investment strategy, but the devil is certainly in the details, so before investing study up or get some help.

Opinions are solely the writer's and are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing involves risk, including loss of principal. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.