How to Invest in Preferred Stock (The Ultimate Guide)
Have you been looking to increase the yield of your portfolio? Are you frustrated by the lack of alternatives to risky high yielding dividend stocks or junk bonds?
If you’ve answered yes to these questions, you may have been overlooking preferred stock.
Wouldn’t you like to get your dividends paid as a priority to regular dividend investors, with that income being generally safer and less volatile, all while getting paid an above average yield?
Preferred stock investments can deliver on that promise.
This Ultimate Guide will demystify investing in preferred stock, particularly individual listed preferred stocks.
It covers all the main elements you need to know, including the “how” to actually invest, augmented with concrete practical examples and insights gained from investing experience.
It will arm you with the knowledge you need to decide whether you want to take advantage of one of the best types of income investments available to you.
Now, there’s a lot of information to cover and this Guide is the longest post yet on Here Income.
So let’s dive right in!
What is Preferred Stock
Preferred stock, also referred to as preference or preferred shares, are a class of stock ownership that can form part of a company’s capital structure.
Just like the regular shares of a company (ordinary or common stock), preferred shares represent an ownership or equity stake in the business.
As the name implies, preferred shares have a priority claim on a company’s assets and earnings and sit just above ordinary stock in the capital structure:
Preferred shares combines features of both common stock and fixed income securities such as bonds and are considered to be a type of hybrid financial instrument.
They are similar to stocks in the sense that they are an ownership stake and pay out dividends but act very similar to bonds in terms of investment characteristics, terms and features.
Why companies issue preferred stock
Companies typically raise capital in two ways, either by taking on debt or by issuing ordinary shares.
If a company needs to raise debt, and they are already quite leveraged, they may be at risk of a credit downgrade by credit agencies, since raising more debt would weaken their debt-to-capital metrics.
While raising more debt would increase the numerator of the debt to capital ratio, issuing preferred shares would increase the denominator (capital portion) and considered to be improving the strength of its overall balance sheet. At least from the perspective of a creditor.
Of course, issuing common equity would have the same effect. However, often, when a company raises capital by issuing common equity, the share price falls because shareholders are diluted.
Preferred shares trade separately from the common so there is often no or much less impact on the common shares when a company issues preferred shares.
This is quite a sneaky approach and common share investors should definitely keep an eye on preferred share issuances, if any, of the companies they invest in.
Types companies that issue preferred stock
In light of the above, it makes sense that preferred shares are mostly issued by companies that need to raise a lot of capital or that have very stringent capital requirements, for example:
- Capital intensive industries such as utilities, energy or infrastructure businesses
- Real Estate Investment Trusts, who need continues inflows of capital since they are required by law to distribute the majority of their earnings as dividends
- Banks, since preferred shares are included in the Tier 1 total capital ratio and can provide a relatively cheap source of this capital.
Let’s now go over some of the main features and types of preferred shares
Features and Types of Preferred Stock
Preferred stock, just like normal shares, can be publicly-listed or privately traded.
In this Guide, we will focus on individual publicly listed preferred stock, since these are much more accessible to the retail investor.
They trade on an exchange, have a ticker symbol and can be bought just like any publicly listed common shares.
A company can have many different issues of publicly-listed preferred shares (e.g. Series A, Series B, Series C, etc.)
Preferred stock generally pay dividends quarterly and are typically issued at a price equivalent to a par value of $25 per share. Some exceptions do exist however, such as shares that pay monthly or that have a different par value (e.g. of $50 per share).
Before we go into detail on the different features and types of preferred stock, let’s look at one example of a preferred stock issue, that of Duke Energy’s Series A Preferred Stock (source: Quantum Online website).
For now, just take note of some of the language and investment terms and don’t worry if you don’t understand all of the elements, we’ll touch on the main aspects in the next section and throughout this Guide.
Cumulative vs non-cumulative preferred stock
Cumulative preferred stock epitomize the word “preferred”.
Essentially, what cumulative means, is that if the company decides to suspend the dividend on its preferred shares (e.g. due to financial difficulties), then all the missed past dividend payments will have to be repaid to shareholders, in full, before common shareholders can receive any dividend at all.
Not a single cent to common shareholders until all owed preferred dividends have been paid!
You could consider this as additional compensation for the fact that issuers of preferred shares can in fact decide to suspend dividends, unlike bonds for which suspension of payments would constitute some sort of default.
Non-cumulative preferred shares don’t have this very beneficial feature and any suspended payments do not have to be paid back.
It is mostly banks that issue non-cumulative preferred shares. This is because only non-cumulative preferred shares are currently considered to be part of a bank’s Tier 1 capital.
Callable (redeemable) preferred shares
The majority of preferred shares are callable.
This means that the issuer has the option, the right but not the obligation, to buy back the preferred shares at a fixed pre-set price, usually equivalent to the liquidation preference (par value, typically $25) of the shares, after a certain date in the future has elapsed.
The issuer is most likely to only decide to redeem the shares if it suits them, typically if they can then re-issue new shares at a lower interest rate.
While in theory preferred shares could be issued as irredeemable in nature, I am not aware of any that possess this characteristic.
Some convertible preferred shares however, are not callable because of their convertibility feature. They are nevertheless considered as redeemable because of this conversion feature.
More on convertible preferred shares at the end of this section.
Perpetual vs term preferred stock
Most preferred share issuances are perpetual in nature.
This means that the shares have no fixed maturity date and will continue to pay indefinitely, as long as the company is still a going concern.
This is different than the majority of bonds, which do have some sort maturity date after which the bond is expected to repay its principal (e.g. 1, 5, 10, 30 year bonds, etc.). Though perpetual bonds also do exist.
It’s relevant to note here that because many perpetual preferred shares have a call feature, it is very likely that the shares will get redeemed at one point or another.
So perpetual, but not really. It just means that they don’t have a mandatory pre-defined redemption date.
Term preferred stock, on the other hand, have a mandatory redemption date, typically with 5 to 10 years of issue, and are quite similar to bonds. They are much rarer and I wouldn’t worry too much about them, especially if you’re just starting out.
Fixed rate versus variable rate
Preferred shares typically provide a fixed-rate dividend, a variable (floating) rate or a combination of both (e.g. fixed-to-floating rate).
Fixed-rate dividends are set as a percentage of the par value and pay out a fixed pre-defined amount, typically on a quarterly basis.
For example, if a preferred share with a par value of $25 has a fixed-rate dividend of 5% it will pay out $1.25 per preferred share annually. The $1.25 per share is “set in stone” and will not change and is typically explicitly mentioned in the prospectus.
Variable rate or floating rate preferred shares on the other hand, as the name implies, pay a variable rate that is determined according to a benchmark rate plus a risk premium.
For example, a preferred share issue may pay out a floating rate dividend equivalent to LIBOR plus 4%.
Of course, the benchmark interest rate can change relatively frequently so many variable preferred shares review the dividend rate on a pre-set periodic basis (e.g. every quarter, year, every five years, etc.) and some even start out at fixed rate, converting to a floating rate on a pre-defined date.
Some preferred shares, albeit relatively rare, incorporate both features together and pay out the maximum (or minimum) of a fixed rate versus variable rate.
Convertible vs non-convertible
Convertible preferred shares, as the name implies, provide the option to convert the preferred shares into a fixed number of common shares after a predetermined date and at fixed conversion ratio.
Depending on the specific issue this could at the company’s option, automatically convertible, or at the discretion of the investor.
Convertible preferred shares are relatively rare and most preferred shares don’t have this feature, i.e. they are non-convertible.
Convertible preferred stock are a bit more complicated to analyse so I wouldn’t worry too much about them, especially if you’re starting out.
Below is an example of a convertible preferred share (again, the source is the Quantum Online website).
Note that in this case there is no call date and that the conversion is triggered at the investor’s option.
This is as close to truly perpetual as you’re going to get when it comes preferred shares.
Participating preferred stock
Participating preferred stock combine the regular payment conditions (e.g. fixed rate dividend pay-out) with an additional dividend based on some predefined condition, typically linked to a performance metric.
Participatory preferred shares are relatively rare and are more complicated to understand, I wouldn’t worry about them, especially if you’re a novice when it comes to the preferred space.
Advantages and Disadvantages of Preferred Stock
Now that you have a good overview of preferred stock, let’s look at their advantages and disadvantages.
This will help you decide what allocation to dedicate to preferred shares, if any, based on your understanding of the asset class and personal situation.
Let’s start with the advantages.
1. High income
The main reason to invest in preferred stock is to benefit from the relatively high income that this asset class can provide.
Of course the actual income level will depend on many factors such as the quality of the issuer, interest rates and the macro-economic environment, but generally most investable preferred shares will exhibit yields in the 4 to 10% range.
2. Income safety and less volatility
Preferred stock income is also generally safe and reliable, especially if you do your analysis correctly (more on how to do that analysis later).
The preferred share dividends are safer than the equivalent common stock dividend given preferred stock’s higher claim on a company’s assets.
This does not mean that the preferred share dividend will always be lower than the common dividend, especially if the issuing company has decent growth prospects.
In many cases, it is possible for preferred shares to provide a higher yield than the common share despite their higher relative safety.
Preferred shares are also less volatile than stocks, also due to this greater safety, along with other preferred share features that could support a valuation at their par value (e.g. they can be called / redeemed at par).
3. Potential for attractive risk-adjusted returns
When it comes to bonds, the preferred shares, will provide a higher yield relative to the bonds of the same company since preferred shares sit lower in the capital structure.
This could be particularly attractive if the issuing company exhibits strong quality characteristics, allowing investors to pocket the higher yield for a minimal increase in risk.
Preferred stock could also be an interesting alternative or complement to high yield or junk bonds that many investors are flocking to in their search for yield.
Again, from a risk-adjusted yield perspective, it could be more attractive to invest in the preferred shares of a quality investment grade company versus investing in the bonds (higher up in the capital structure) of a non-investment investment grade company.
Let’s not ignore capital gains either, preferred shares can deliver substantial capital gains in combination with a high yield, if bought at a discount to their par value and/or in a falling interest rate environment.
Of course, bonds and dividend stocks can also exhibit these characteristics but adding preferred shares to your investing toolbox, will at the very least increase your opportunity set.
Let’s not forget that the preferred share market is much smaller than the common equity or bond market.
Issues of preferred shares are relatively small in size and low in liquidity. As a result, competition from institutional investors is also relatively low.
This means that the preferred share asset class exhibits market inefficiencies more regularly, allowing shrewd investors to identify and take advantage of the resulting opportunities.
4. Ease of research
Preferred shares, once you’ve identified candidates that is, are much easier to analyse compared to common stocks.
When you’re investing in common stocks, you need to have a strong thesis, based on thorough evaluation of a company’s future prospects and valuation.
With preferred shares, the focus is on assessing safety and avoiding severe risks of bankruptcy and dividend suspensions.
Preferred stocks share this characteristic with bonds.
However, preferred stock investment candidates are arguably easier to identify than bonds because companies generally have many more separate bond issues than preferred shares.
Also many bond issues require a huge amount of capital to access (e.g. six figures), making it time consuming to identify those that are investable in smaller denominations.
Listed preferred shares, can also easily be bought through your broker just as you would buy a regular common share.
Finally, since they are a separate asset class, preferred shares can provide additional diversification to a portfolio, and allow you to add an extra source of passive income.
I will not over-elaborate this point, because their diversification benefits to an equity portfolio are not to the level of that provided by bonds, cash or gold.
And this sums up the main advantages of preferred shares. I’m sure you’ll agree there’s quite a lot to like.
But as with any investment, there is always a downside.
So let’s go over the main disadvantages of preferred stock.
1. Interest rate sensitivity
Preferred shares are interest rate sensitive, as with all fixed income investments.
If you understand the mechanics of interest rate impact on bonds, it’s basically very similar for preferred shares.
If interest rates rise and you are holding a preferred share paying out a fixed rate, then the price of the preferred share will fall.
After all, newly issued comparable preferred shares would be paying out a higher yield due to the higher interest rate market conditions so your preferred shares issued with lower yield would be less attractive as a result.
This is why the price of your shares would fall. To equalize the returns across comparable investments. Market forces at work.
Conversely, if interest rates fall, then the value of your preferred share will rise.
Also, there’s another very important risk to point out, which is the return asymmetry inherent in fixed rate preferred shares.
Since most preferred shares are callable, what usually happens is that if interest rates fall, the price of your preferred shares will rise but will slowly return to close to par value as the call date approaches.
This is because a company will be incentivized to redeem the shares (at par) and re-issue them at lower prevailing interest rates, thus reducing its costs.
So if interest rates fall, you’ll get some short term upside if the call date is still several years out, but your upside is essentially capped in the medium term.
If interest rates rise, then the company will have no incentive to redeem the shares and so you’ll be left holding them.
Potentially indefinitely, since most preferred shares are perpetual in nature and if rising rates persist, you could be left earning below market yields and having considerable paper losses to show for it.
Luckily, there is also the potential for companies to redeem preferred shares even in a rising interest rate environment due to other reasons.
This could be due to strategic decisions resulting in a change to the capital structure or a desire to reduce outgoings in preferred dividend expenses to re-invest or boost returns to common equity stakeholders.
That’s why interest rate sensitivity in preferred shares is often considered to be lower than that of long term bonds of 30 years or more despite the fact that most preferred shares are perpetual in nature.
One way to mitigate against changes in interest rates in preferred shares is to invest in variable rate or fixed-to-floating preferred shares.
This makes the value of preferred shares much more stable, but you should willing to accept some variability in the income stream, mirroring interest rate fluctuations, both to the upside and downside.
2. No income growth
Preferred shares, as with bonds, do not provide for income growth and you don’t get rewarded with growing dividend payments if a company continues to be successful over time.
This privilege is reserved to investments in dividend growth stocks.
The lack of income growth, assuming the preferred share is paying a fixed rate, also means that the purchasing power of your dividend payments will slowly decrease over time due to inflation.
This could arguably be acceptable, since you could be generating a sufficiently high yield today.
3. Relative illiquidity
Preferred stocks are relatively illiquid, especially when compared to common stocks. This essentially means that there may not be enough shares for sale when you want to buy or demand for the shares when you want to sell.
This results in potential price execution risk if you place a market order and in a more elevated bid – ask spread.
However, this is not really a big problem and it can easily be mitigated by always placing a limit order when transacting in preferred shares.
It could also be useful to look at the trading volume of your candidate preferred share before investing.
This illiquidity also may limit you if you’re looking to place very large orders.
Worst case scenario a partial order will be executed, buying or selling a portion of the desired quantity.
4. Industry or sector limitations
As was mentioned earlier, preferred shares are mostly issued by banks, other financial institutions and capital intensive industries such as REITs, energy, utilities and infrastructure companies.
This leaves a lot of attractive industries such as the technology sector, healthcare, industrials, etc. out of the picture.
So, by nature, you can’t have a broad sector allocation by investing in preferred shares.
You may want to limit common stock investments in industries or sectors that are known for issuing preferred shares allowing you to increase your allocation to preferred shares in these sectors.
Generally, it’s important to consider the overall allocation of your portfolio to the sectors you invest in, regardless of the asset classes through which you have this exposure.
5. Non-standardized ticker across brokers
Finally, one of the disadvantages of preferred stock is the fact that different stock exchanges, brokers or financial websites use different conventions for preferred stock symbols.
Here are some examples (source: Quantum Online website)
If this looks very confusing, I’d agree but don’t let it be a reason to be discouraged.
After all, whatever the convention, they all have something in common. Taking the example of Alabama Power they all have in common:
- the main ticker of the common stock
- the preferred series (e.g. “N” referring to Series N,)
Once you figure out the convention that your specific broker uses once, you’ll be able to do so for all your future preferred stock investment candidates.
You’ll definitely figure it out soon enough!
How to Analyse Preferred Stock
Now that you (hopefully) have a good overview of what preferred shares are all about, let’s go over the key aspects that will help you actually analyze preferred stock.
And the best way to do so is by using a practical example.
We’ll use Rexford Industrial Realty, 5.625% Series C Cumulative Redeemable Preferred Stock.
Please note that information related to the example will be outdated by the time you read this so don’t focus too much on the example itself but, rather, on the analysis.
Here is the overview of REXR-C (source: Quantum Online website)
As we can see, this Series of preferred stock is cumulative, callable in 2024 and pays a fixed coupon of 5.625% annually. It has a liquidation or par value of 25$ per share.
Don’t just read the name of the series to check if it’s cumulative or redeemable because it’s not always in the title.
For example, in this case we don’t see the word perpetual in the name of the preferred share (while in other preferred shares it is sometimes indicated).
We know it’s perpetual because the text says “with no stated maturity” in the 3rd sentence.
The text comes from the preferred stock prospectus, which you should always consult before investing to double check.
Just like you should consult the actual financial statements before investing in a company and not rely solely on the data from financial websites.
You can access the prospectus through the clickable “Link to IPO Prospectus” at the bottom of the screen. You could also access it through the company’s investment relations page.
Quality and Safety
Before you pull the trigger on a preferred stock investment. It is important to analyze the quality of the company and the safety of its preferred dividend distributions.
Luckily, regarding the quality of the company, only a relatively superficial analysis is required because preferred stock dividends are generally safe and you don’t need to assess the company’s growth prospects going forward.
Overall quality of the company
One of the easiest way to assess the company is to look at its credit rating. If it’s investment grade, then generally you’re probably good to go.
Just make sure to quickly go over some news on the company and do some basic research on the share price trends and the financials, just to make sure you’re not missing any current or imminent problems.
In the case of our example, at the time of writing at least, Rexford Industrial Realty has an investment grade credit rating according to S&P of BBB.
If you’re interested in a preferred share that is non-investment grade, a more detailed analysis of the company’s prospects is required but only to the extent necessary to determine whether there is any risk of severe issues in the medium term.
I would suggest limiting yourself to investment grade issues when you start out if it makes you more comfortable.
However, as we will see in the next section, the most important thing is really to assess the safety of the preferred dividends.
Preferred dividend safety
Let’s kick-off this section with a general guideline on preferred dividend safety. It relates to the capital structure.
You want the company to have as little debt as possible and as much common equity as possible.
This makes sense because preferred shares have a lower priority than debt and a higher priority to common shares.
If 80% of the capital structure is debt, then you’re standing quite far at the back of the line when it comes to a claim to the company’s assets.
Interest payments are also likely to be substantial as a proportion of earnings or cash-flow, leaving less money left over to pay the preferred and common stock dividends.
Conversely, if the company is 80% comprised of common equity, then you’re in the top 20% as a preferred shareholder. Since preferred stock sits higher than common equity in the capital stack.
It’s also beneficial for the company to have a small percentage of its capital structure in preferred shares.
It means that preferred share dividends will be a small portion of a companies’ cash outflows.
This makes it a lot more likely for companies to consider them as they do their debt and honor the payments, even in times of financial difficulties, since cutting them would result in very little savings at the cost of antagonizing the whole class of preferred shareholders.
Let’s get back to our Rexford Industrial Realty (REXR) example, which will hopefully makes things more concrete.
Here is REXR’s capital structure as November 2020 (source: Final November 2020 Rexford NAREIT Investor Presentation)
As we can see, it’s very attractive for the preferred shareholder. 80% of the capital structure is common equity meaning that none of the common shareholders can get paid a dividend (a REIT’s “raison d’être” unless preferred shareholders get made whole.
We also see here that preferred equity makes up a very small portion of the capital structure meaning that the preferred dividends are likely to just be relative pocket change for the company.
So far so good! REXR’s preferred shares fit the bill according to the general guideline.
Let’s now dig a little deeper into the preferred dividend safety by looking at REXR’s cash-flows and preferred dividend coverage.
Below an extract related to its Fund from Operations, also from their November 2020 investor presentation. The important elements are highlighted in the orange boxes.
If you’re not familiar to the term Funds from Operations, it is a key cash-flow metric reported by, and used to analyse, Real Estate Investment Trusts.
If you’re analysing the preferred share of a regular corporation, simply do the analysis using normal cash-flow metrics such as operating cash-flow and free cash-flow.
As we can see, the quarterly preferred stock dividends paid out by REXR amount to $3,637,000, which is but a very small fraction of its Funds from Operations of $44,652,000.
Very easily covered. More than 12 times preferred dividend coverage.
Now let’s assess the common dividend safety, because after all, if the common dividend is safe, then the preferred share dividends are that much safer.
At the time of writing, REXR is paying a common dividend of $0.215 per share per quarter.
If we multiply this amount by the weighted-average shares outstanding in the table above of 120,068,000 shares, we get quarterly common dividend cash outlay of $25,814,620 per quarter.
As we can see, this is easily covered by Funds from Operations (FFO) or Company Share of FFO (the latter is net of preferred stock dividends).
Instead of FFO you could use Adjusted Funds from Operations if the company reports it (or if you want to calculate things your way) and of course you could run the numbers annually instead of quarterly.
I adapt my analysis to the data provided by the company because it makes things easier.
Now I don’t want to go into too much depth on this and there’s really no need to.
It’s really that simple, the common dividends are safe and the preferred dividends are very safe.
For the dividend and dividend growth investors out there, if you can analyse the dividend safety of a dividend or dividend growth stock, then you can definitely analyze the dividend safety of preferred shares.
Specific note on REIT preferred shares
I want to end this section with a specific note regarding the particular attractiveness of REIT preferred shares.
These are generally cumulative, and since REITs are required to pay out most of their earnings as dividends to common shareholders, by law, the preferred shares are relatively safer than those of regular corporations.
Basically a REIT can’t completely suspend its common dividend payments if their earnings are positive, even if they wanted to.
However, when it comes to regular corporations (C-Corp), they may opt to completely suspend dividends even if they have good earnings (e.g. to fund an acquisition, invest internally in the business, etc.) and they can do so indefinitely.
So if a profitable REIT is obliged to pay out common dividends, common dividends will be paid and so will preferred share dividends since they have priority.
I highly recommend using REITs for a significant portion of your preferred allocation. It’s also why I used a REIT as the main example of this Guide.
Yield and valuation
Now that you hopefully have a good overview of how to assess the safety of a preferred share, let’s look at the ways to analyze the yield and valuation of a preferred share.
Just like with any investment, it is critical to buy at the right price. You can never ignore valuation just like you can’t ignore assessing the profile of the underlying company and its fundamentals.
They must always go hand in hand.
We’ve already assessed the quality of Rexford Industrial Realty and the safety of its preferred dividends and determined that it passed our criteria.
Let’s use the same example to look at the yield and valuation.
Below some Key Stats, at the time of writing of REXR Series C, from preferredstockchannel.com, one of the best free websites to use to research preferred shares (I have no affiliations with them)
As you can see, the Market Price in this example is $26.92 representing a premium to the $25 Liquidation Preference (par value) of 7.68%
REXR-C pays an annual preferred dividend of $1.406262.
At the par value of 25$, this represents a yield of 5.625% that, unsurprisingly, is the Original Coupon and headline yield in the preferred share title and prospectus.
However, were you to buy at the Market price of $26.92, you’d still receive that same $1.406262 dividend per share. You’d be acquiring the shares at a Current Yield of 5.22% (as indicated in the table).
You may be thinking to yourself that a yield 5.22% is still very attractive given the quality and safety of the preferred shares and you would be right, but there’s a very important caveat.
Don’t forget that $1.92 premium over par since if or when the shares get called, you’d only get back $25 par value per share.
So you need to factor in that $1.92 premium in your return calculations.
Let’s do that right now.
Since this Guide was written at the end of 2020, there’s still roughly 3.75 years until the potential call date.
Let’s call it 4 years for simplicity and to demonstrate that you don’t need to be overly exact if you want to screen investment candidates quickly.
Let’s also assume the premium was $2, again for simplicity, equivalent to 8% premium over par (instead of 7.68%)
If we divide the 8% by 4 years, then it would result in a loss averaging 2% per year. We ignore compounding, staying with that simplicity frame of mind.
If we deduct an extra 2% from our return then, we would get an effective yield of around 3.22% according to our back of the envelope estimate.
If you want a more exact calculation, divide the $1.92 premium by 3.75 years to get a $0.512 average loss per year that you then subtract from your annual dividend of $1.406252.
This essentially means that you’d be getting an average of $0.894252 per year if the shares get called at the call date, which at the current Market Price of $26.92 would result in an effective yield of 3.32%.
A lot less exciting I’m sure you’ll agree.
Of course, if the shares don’t end up ever being called or called 20 years later, then you’ll amortize your premium over a very long duration, which would increase your effective yield and bring it closer to the headline rate.
However, I strongly recommend always doing your calculations assuming your shares will be called at the call date because that is your worst case if you’re investing at a premium to par.
Essentially, you should consider the call date to be the maturity date of the preferred share. This guideline will protect you.
If the call date for a preferred share has already passed, then you should absolutely refrain from buying at a premium unless you really know what you’re doing because “what if the company decides to redeem your shares the day after you pull the trigger?”
Instant capital loss. In our example, we if assume the call date was yesterday and the shares got called today, that would be an instant 7.92% loss.
The opposite is true if you buy a share at a discount to par. You don’t mind at all if the shares get called earlier, because it would actually increase your return.
And the same calculation as I outlined earlier would apply, except that you would need to factor the discount to par in your effective yield calculation, which would result in a higher yield than the headline rate.
Let’s assume that shares were trading at a Market Price of $24 instead of $26.92. A discount of $1 per share to the $25 par value.
Again if we assume 4 years until maturity (which we consider as the call date), then this would translate into a $0.25 extra benefit per year.
If we add this $0.25 to the annual preferred dividend of $1.406252 and divide this buy the Market Price of $24, we get a whopping 6.9% return if the shares get called.
Much higher than the original coupon of 5.625%.
I hope you can see now the power of buying at a discount to par.
Let’s get back to our example so as to conclude.
REXR-C preferred shares, at a price of $26.92, are overvalued because they are trading at a substantial premium to the par and the realized return should they get called in 2024 would be low.
But since we’ve already concluded that REXR is an attractive company with safe preferred dividends overall, it should be added to a watch-list to take advantage of any price dips (full disclosure, I bought REXR-C at a price $24.26 in the first half of 2020).
Specific note on buying preferred shares at a premium
It may be OK to buy shares at a very slight premium to par (e.g. at $25.25) if the call date is quite far out because the impact on your return would be negligible, if you’re happy with the yield that is.
Also, sometimes, shares will trade at a very slight premium because the next dividend pay date is approaching, so you will essentially be reimbursed that premium immediately through the imminent dividend.
You can essentially factor this “accrued” dividend in your yield calculations. This is known as the stripped yield.
I personally don’t really factor it in my decisions unless I’m buying at a very slight premium to par and the call date is relatively close or has already passed for the preferred share investment candidate.
Finally, some preferred shares are not callable because they have a conversion feature instead. If the conversion feature is very unlikely to be triggered, and if the yield is very interesting, it may be OK to buy above par.
I will stop right here because it’s really a small point that is reserved for more experienced preferred investors, I just wanted you to be aware of it.
If you’ve made this far, well done! And thank you for sticking with me. This Guide’s turned out a lot longer than expected but there was a lot of information to cover.
Practical recommendations on how to invest in preferred shares
I would like to conclude with a synthesis covering my practical recommendations for investing in Preferred Shares.
It will put the key take-aways in a practical context.
- Identify listed preferred stock ideas. Here are the sources I personally use (I am not affiliated with them in any way but wholeheartedly recommend them):
- Consulting the master list of preferred shares maintained by the true hero(es) over at com
- Seeking Alpha, where authors sometimes write about preferred shares in the Dividend section, the article comments can also be a good source of ideas
- Look out for preferred shares when you analyze financial statements of companies (particularly those in industries known to issue preferred)
- If you’re open to investing in Canadian preferred securities, then ca is an excellent resource.
- Research your preferred shares:
- Prioritize Fixed Rate, Cumulative, Perpetual, Redeemable/Callable Preferred stock if you’re starting out
- Consider prioritizing your research on REIT preferred stock since they are required to pay-out dividends to common shareholders if they are profitable
- Make sure you consider the impact of the preferred stock candidate on your overall portfolio sector allocation
- Check the company credit rating (Google Search), you may want to focus solely on Investment Grade companies when you’re starting out
- Conduct a brief analysis of the company through Google Search on news and share price trends and consulting financial reports and/or earnings or investor presentations)
- Conduct an analysis of preferred dividend safety to make sure that preferred stock dividends can very easily be covered by the company’s cash-flows (information can be found in investor presentations, earnings reports or annual filings)
- Consult Quantum Online and Preferred Stock Channel by typing the Preferred Ticker followed by Quantum Online or Preferred Stock Channel in Google, for prospectus information and pricing related to your preferred share candidates
- Analyze the yield and valuation, making sure to take into account the premium or discount in your calculations
- Make sure you understand the tax impact based on your personal situation
- If the preferred share is attractive but overvalued, put it on your watch-list. Try to aim for a discount to par as a general rule so be patient.
- Buy the preferred share:
- Find the preferred share stock ticker convention that your broker uses
- Put in the quantity and a limit order to mitigate any liquidity issues
- Click on Buy!
- Remember the potential return asymmetry inherent in preferred shares (capped upside to unlimited downside) and invest in them as a complement to your core equity and bond positions (limit of 5 to 20% of your portfolio)
Finally, if all of this still sounds too complicated (despite my best efforts) or because you are really looking for a very hands-off approach, then you’re in luck because there are alternatives to investing in individual listed preferred shares.
In my view, the next best way to invest in preferred shares is through Closed-End Funds because they are better structures than Open-End Funds for investing in relatively illiquid securities such as preferred shares.
It is possible to identify funds that outperform the indices when it comes to this type of securities. I personally also use Closed-End Funds as part of my preferred share allocation.
My third best way to invest in preferred shares, also has the benefit of being the easiest. It’s through preferred share ETFs.
However, the offer of preferred ETFs is very limited for those without access to the U.S. ETF markets.
Irrespective of the investment vehicle that suits you best, consider increasing the yield and income stability of your portfolio by including preferred shares as part of your fixed income allocation.
So, are you ready to give preferred shares a go?