Why Preferred Stocks May Be the Hidden Gem in Your Portfolio
Investing in the stock market often brings to mind common stocks, the shares that typically carry voting rights and offer the potential for capital appreciation. However, lurking quietly in many portfolios is another class of equity that is frequently overlooked: preferred stocks.
Preferred stocks occupy a unique space in the investment world, blending elements of both stocks and bonds. This hybrid nature gives them qualities that can add stability, income, and diversification to your portfolio.
In this article, we’ll explore what preferred stocks are, why they deserve a closer look, and how they can serve as a valuable component in your overall investment strategy.
What Are Preferred Stocks?
Preferred stocks are a class of ownership in a company that has characteristics of both equity and debt. Unlike common stocks, preferred shares typically do not carry voting rights, but they do offer investors a higher claim on assets and earnings. Preferred shareholders receive dividends before common stockholders, and those dividends are usually fixed, much like interest payments on bonds. In case of liquidation, preferred shareholders have priority over common shareholders in receiving company assets.
There are several types of preferred stocks, each with its nuances. Cumulative preferred shares, for instance, guarantee that if dividends are missed, they must be paid out before any dividends can be given to common shareholders. Non-cumulative preferred shares do not have this guarantee. Convertible preferred stocks allow investors to convert their shares into a predetermined number of common shares, offering potential upside. Participating preferred stocks can share in additional earnings beyond their fixed dividends under certain conditions. These varieties allow investors to tailor their investment goals with different risk and return profiles.
Preferred stocks tend to attract investors who seek steady income but want to avoid the higher volatility of common stocks. They are especially appealing to income-focused investors, such as retirees, who prioritise dividend income and capital preservation. Check here for further information.
Key Features of Preferred Stocks
One of the defining features of preferred stocks is the fixed dividend. Unlike common stocks, where dividends can fluctuate or be skipped entirely, preferred stocks typically offer a fixed dividend that is paid regularly, providing a predictable income stream. Because of this fixed income characteristic, preferred dividends are often compared to bond interest payments.
Preferred shareholders also have priority when it comes to dividend payments. The company must pay all dividends owed on preferred shares before any dividends can be paid to common shareholders. This priority extends to the event of liquidation; preferred shareholders are ahead of common stockholders in the pecking order for any remaining assets after debts are paid.
On the flip side, preferred shareholders usually do not have voting rights, which means they cannot directly influence corporate governance. This trade-off is part of the hybrid nature of preferred stocks, which blend characteristics of debt (fixed income and priority in claims) and equity (ownership in the company).
Advantages of Including Preferred Stocks in Your Portfolio
Preferred stocks offer several benefits that make them attractive additions to many portfolios. First and foremost, they provide a stable and predictable income stream through fixed dividends. For investors who rely on their investments for income, this predictability is highly valuable.
Compared to common stocks, preferred stocks generally experience lower price volatility. This can help smooth out portfolio fluctuations, making preferred shares a more stable income source during periods of market turbulence. Additionally, preferred stocks often yield more than bonds and common stocks, which can enhance overall portfolio income.
In some cases, dividends from preferred stocks may receive favourable tax treatment, depending on the jurisdiction and account type. This can further improve their attractiveness for income investors.
Risks and Drawbacks of Preferred Stocks
While preferred stocks offer many benefits, they come with risks that investors should carefully consider. One major risk is interest rate sensitivity. Because preferred stocks pay fixed dividends, their prices tend to fall when interest rates rise, much like bonds. This means that in a rising rate environment, preferred stock prices may decline.
Credit risk is another concern. Since preferred stocks are issued by companies, the possibility of default exists. If the issuer experiences financial trouble, dividends may be suspended or the value of the preferred shares may drop significantly. Unlike bondholders, preferred shareholders are lower in the hierarchy for claims on assets if a company goes bankrupt, though they still have priority over common shareholders.
Finally, preferred stocks often have a call feature. This means the issuer can redeem the shares after a certain date, usually at a premium. While this can be favourable for the company, it poses reinvestment risk for investors, who may have to replace the shares with lower-yielding investments if rates have fallen.
Conclusion
Preferred stocks are frequently overlooked but can be a valuable, “hidden gem” within an investment portfolio. Their unique blend of fixed income, priority claims, and equity ownership provides stable dividends, lower volatility, and diversification benefits. While they do carry risks such as interest rate sensitivity and limited capital appreciation, these can be managed with informed selection and strategic allocation.
