Preferred Stock – A Comparison with Common Stock and Bonds
Global Asset Management Seoul Korea Report
In response to an increase in client inquiries on this topic, GAM Korea has prepared a fact sheet for general information about preferred stock. Like common stock, preferred stock represents shares of ownership in a company. They are both equities. In terms of asset class, preferred shares perform as a type of hybrid between common stock and bonds. Some aspects are similar to ordinary common stock, and some more similar to bonds. Preferred shares usually pay higher yielding dividends, attractive in our current low-interest rate environment.
The Four Types of Preferred Shares
- Cumulative Preferred Stock: These require the issuer to accumulate any deferred payments and pay them to the shareholders in the future. This must be done before any dividends can be paid to common shareholders.
- Non-Cumulative Preferred Stock: These preferred shares have no claim over missed dividends. They tend to have higher dividend yields than cumulative shares to make up for the higher risk.
- Participating Preferred Stock: These entitle shareholders to participate in earnings above and beyond the fixed dividend. They trade at a premium, and therefore a lower yield.
- Convertible Preferred Stock: These give the shareholder the right to convert the preferred stock into a fixed amount of common stock after a particular date.
Attributes of Preferred Stock
The main attraction of preferred stock is that they pay higher and more consistent dividends. In terms of risk, they fall somewhere in the middle of stocks and bond. Dividends of preferred shares have priority over dividends of common shares, but they are not guaranteed, as they are in a bond, which is a contractual arrangement. Preferred stock usually pays higher dividends than common shares but it’s important to understand that dividends aren’t guaranteed. They are a disbursement of company earnings to shareholders, just like with common stock. The difference is they have priority.
A secondary attraction is that dividends are taxed more favorably than interest income. Bond interest payments are taxed as regular income. It’s important to always consider the after-tax yield when comparing preferred shares with bonds.
The main risk is that they are very price sensitive to changes in interest rates. They react like bonds and have an inverse relationship between interest rates and prices. When interest rates rise, preferred share prices drop. When rates drop, share prices increase. Also, the company can call back the preferred shares, leaving the owner with the burden and cost of reinvestment. For example, if interest rates drop, the company may call certain preferred shares back and reissue them at a lower dividend. A final issue, as opposed to a risk, is that preferred shares have no voting rights. Owners have no say in electing a board of directors or approving a takeover. Common stock, on the other hand, has voting rights. This is not a concern for the average investors, just something to be aware of.
Preferred vs. Common
- Preferred stock has no voting rights. Common stock has voting rights
- Preferred stock has priority in receiving income disbursements. Paid dividends before common stock.
- Common stock is last in line for assets. If a company goes belly-up, the priority is creditors, bond holders, preferred stock then common stock
Over the long term, as an asset class common shares tend to outperform preferred stock and bonds. Common shares have the largest potential for capital gains and the largest risk of capital losses. Some preferred shares can be converted to common stock, but never vice versa. It is at the discretion of a company’s board of directors whether to pay a dividend. If a company is low on cash, preferred shareholders have priority getting paid. Hence the term ‘preferred’. During insolvency, preferred shareholders have priority in terms of both income and payout from sales of assets.
Read more: Asset Allocation
Preferred vs. Bonds
- A bond represents a loan made to a borrower from an investor
- Preferred shares represent ownership in a company
- Bonds pay income; preferred stock pays dividends
- Bonds have a maturity date, preferred shares can continue indefinitely
- Bondholders have priority over preferred shareholders getting paid out in the event of bankruptcy.
Bonds are a type of fixed income security representing a loan made to a borrower (government or corporate). Investors who own a bond are considered creditors of the borrower. A bond has a maturity date when the principal is paid to the current owner of the bond. The owner then has cash which may need to be reinvested. Preferred shares continue indefinitely, unless they are called. Bond maturity dates are fixed and predictable, which has advantages for aspects of portfolio planning, like establishing ladders. Bonds are liquid, and can be sold if the owner does not want to hold to maturity (unlike many bank guaranteed investment certificates).
There are two types of bonds: secured (asset-backed) and unsecured. Secured bonds are “secured” by company assets, much like collateral for a personal loan. In the event of bankruptcy, the bondholders will receive all or most of their original principal back. Unsecured bonds have no such security and the holders unlikely to receive distributions.
Recommended read: Bond ladders – Simple and effective
For more information, please contact Global Asset Management at their Seoul, Korea office.