What are Preferred Shares? All you need to know about preference shares
Preferred shares are an interesting type of security available to investors with many of the attributes of fixed income investments, but they are not the same as bonds. Although it has the characteristics of bonds, it also trades on major stock exchanges like common stocks, but it is still a completely different type of investment.
With this in mind, in this article we will help you form a general knowledge of what preference shares are, how they work, and what investors should consider before they start investing in this type of stock. We will also discuss whether it is better to invest in individual blue-chip stocks or to invest through index funds.
What are preferred stocks and how do they work?
Preferred stocks are not purely stocks (at least not in the sense that most people think) and they are not purely bonds either. They are somewhere between the two. Like bonds, preference shares are a form of fixed income security. They pay dividends to investors on a set schedule and are designed to generate income, not growth. This is the most important difference between ordinary shares and preferred shares. Say you buy a preferred stock for $25 with a 5% yield, you will receive $1.25 per year in dividend income.
Here’s an important point to know, if a company’s common stock doubles in value, it is unlikely that preferred stock will do the same as you are not participating in stock appreciation arising out of or related to the business. Granted, the price of preferred stock can usually move in response to fluctuations in interest rates or the perceived health of a business, but the price is not linked to the earnings of the underlying company.
Unlike bonds, preferred stocks can be easily traded on the major stock exchanges as they have a lower rank than bonds in a company’s capital structure. Preferred stock returns can be fixed or variable based on the rate of interest criterion. Preferred shares can last forever or have a fixed maturity date such as when the company pays the investors the original value of the shares and they retire. Like bonds, preference shares may be callable, which means that the company has the right, but not necessarily, to redeem the shares on a certain date if it so chooses.
What to consider when choosing preferred stocks for investment:
There are a number of elements that are important to consider when choosing preferred stocks to invest your money in:
Preferred stocks are inferior to bonds when it comes to claims on a company’s assets. In other words, in the event of bankruptcy, bondholders will get paid first before preferred stockholders can recoup their investment. In a company’s capital structure, preferred shareholders are superior to common shareholders but are not significant debt holders. On the plus side, this is why preferred stocks tend to pay higher returns than bonds in the case of the same company. However, it is important to keep in mind that this additional return is compensation for the somewhat higher level of risk faced by the preferred shareholders.
The important question that must really be answered is whether the premium stock is permanent or not, meaning whether it will continue to exist indefinitely, or whether it has a specific date to stop its existence. It is also important to know if a preferred stock is callable so that the company can choose to redeem the shares and pay the investors par value for them at any time.
Another consideration is whether the Preferred Share is convertible which means that the shares can be converted into ordinary shares at a predetermined conversion rate. This combines two potential perks: the higher income paid by preferred stock with the potential upward potential if the common stock performs exceptionally well.
All of these details about each particular preferred stock should be in a prospectus that can be obtained from the Securities and Exchange Commission or on each company’s Investor Relations webpage. Many companies that issue multiple series of blue-chip stocks also publish investor-help guides that highlight the differences between each type (for example, check out the Bank of America (NYSE: BAC) Blue-chip Stock Guide).
The best way to invest in preferred stocks:
You can certainly invest in individual blue chips. The vast majority of preference shares are issued by financial institutions and are also very popular among telecom providers, energy companies and utilities. However, there are some companies in other sectors that issue preference shares as well.
In all cases, there are two downsides to investing in individual preferred stocks. First, just like investing in individual common stocks, there are risks associated with relying on the performance of a single company for your investment returns. Second, it can be difficult to find information about specific preferred stocks (what’s available, maturity dates, stock symbols, etc.) and can be very complex to understand.
For the majority of investors, adopting index funds to invest in blue-chip stocks is the best option. The iShares US Preferred Stock ETF (NASDAQ: PFF) is the largest premium margin trading fund on the stock exchange and allows investors to place their money in a broad basket of preferred stocks. While the fund’s expense rate of 0.46% is on the higher end for an index fund, investing in index funds can still be a smart way to add blue-chip stocks to your portfolio without doing the homework of picking individual blue-chip stocks yourself: which would require A lot of research, knowledge and perusal, in addition to a lot of time and effort. The Invesco Preferred ETF (NYSEMKT:PGX) is another good option that investors might want to consider with a similar objective and return to the iShares fund.
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