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How to Invest in Preferred Stocks | The Tutorial (Part II Of A Series)

Updated on October 9, 2014

As I mentioned in my last article, it is my belief that preferred stock investing is one of the most overlooked types of investments by the average non-institutional investor. The only thing preventing more people from investing in them is a basic lack of understanding on how to profit from this investment type

Now that I have explained the basics of what preferred stocks are along with terminology (see last article for a list of terms that I will use going forward) , lets get into how you can use this type of investing to your advantage. But first, a few other things along with some reiteration of some important points.

First off, preferred stocks are much less volatile than regular stocks. They will fall on their ex-dividend date by an estimated amount, generally by the amount of the dividend. They will then usually regain their value gradually before their next ex-dividend date. There are only a few things that will cause a preferred to drop rapidly. The first is a business event that would portend a suspension of dividends. Because preferreds do not appreciate in share value much over time, the regular dividend is the reason for holding them. If investors believe dividends will be cut they will sell the shares.

Now, with that being said, this is not always the case. If an issue is cumulative the investor will be made whole at some point by getting those dividends placed in arrears once business conditions improve. If a company is judged stable you will see these issues go UP in price because there are dividend amounts attached to them. So for example, if the company suspends dividends of $1/share every quarter but misses payments for three quarters, then if dividends resume in the fourth quarter the investor that holds the shares will get $4 in dividend payments. If the share price was $25 at the time of suspension then it will likely rise to $29 by the ex-dividend date of payment because that money is baked in the cake as they say.

It bears repeating that preferreds may drop in price due to a rise in interest rates. This is because of the risk and reward paradigm. A money market account carries little risk but if it only pays .01% then an investor is willing to take on more risk to get a higher rate of return. If interest rates rise, lets say to 1%, then some investors will be more willing to keep their money in these safer accounts and will move out of preferreds. Every time interest rates rise a preferred stock will as a general rule dip in value by an amount equal to what the interest rate is. The biggest enemy is a rapid rise in interest rates where an investor has little time to re-balance or get out.

In contrast, if you own preferreds in a time of interest rate declines, the shares will appreciate in value AND give you regular dividends. This is an ideal situation. As I will mention in a later article, for someone approaching retirement this can be an excellent way to provide a steady income that can beat inflation. It is actually the best of both worlds and can be a life changer for some.

A word of warning that must be mentioned. In the 2008 financial crisis the stocks that got hit the hardest and dropped the fastest were Preferred Stocks, most of which are issued by financial institutions. Once Lehman Brothers went defunct there were many other banks that were also thought to be on the verge of bankruptcy. When an investor believes a company may go bankrupt they sell, and sell hard. Many preferreds dropped by over 50% within a couple months. This was described by many as a once in a lifetime event similar to the stock market crash the began the Great Depression. Everything besides Gold, the ultimate defensive investment, tanked.

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With that being said, once the companies were deemed to be stable and not going out of business, the stocks recovered. The rise was a rapid V shaped ascension back to normal values within a few months. A retrace that took common stocks five years. This is obviously not a normal event, but the gravity of the situation at the time caused a meltdown not seen in a couple generations.

So, now that you understand the risks, let get into how you can profit from making these stocks part of your investment portfolio.

First off, how do you find out what issues are available?

The best site I have found is Quantum Online (www.quantumonline.com). A membership is free and you do not have to provide any payment or personal information. They have functionality for you to make a donation if you feel like it (which I strongly encourage), but again, it is not required. Once logged in you can utilize a top notch screener that lets you find issues on many factors. Refer back to my previous article for definitions of the terms.

So lets say you want to dip your feet in and find a very safe stock that returns an annual rate of at least 5%. Running through the screener you find issue PSA-Y, a Public Storage Stock issue. Moodys rates the company A3, which is a very high rating. This means Public Storage's financials have been studied by the ratings agencies and they judge their likelihood of default to be extremely low. The issue pays interest quarterly at an annual rate of 6.38%. The company does not have the right to redeem the shares until March of 2019.

Preferred Stock Examples

Preferred Stock
Interest Rate
Rating
Call Date
SPG-J
8.38%
A3
10/15/2027
PPS-A
8.5%
Baa3
10/1/2026
HPT-D
7.13%
Baa3
1/15/2017

You do a search and find these shares to be selling for $25.63 at current market rates. This is $ .63 more than the face value. Why are they higher? Investors are willing to pay a premium to get a 6.38% return on their money. The calculations go like this. The company cannot call the shares in until March of 2019 at the earliest, so anyone who invests in the stock will receive about four and a half years of dividends before the company can call the stock in. So, doing the calculation if you buy the stock now at $25.63 and hold it until March of 2019 you will get $7.17 in dividends per share. Accounting for the initial share premium, IF the company calls in the stock on the call date you will get a 5.8% return on your money. Note that they do not have to call the stock. It has no maturity date so they can keep it out forever. If they do not call it in you will continue to receive the annual 6.38% on your money.

There are countless other issues you can find, some which pay more, some less. Rates are determined by what the company deems the market will buy. So, for a company that doesn't have a rating with Moodys they may be willing to pay 8, 9 or even north of 10% for the use of your capital.

Once you begin to understand how these issues work, you can start to add issues to your portfolio that will work with your investment goals. There are different tips and strategies that you can use which we will cover in subsequent articles.

In summary, preferred stocks offer investors a way to accumulate a steady stream of dividends in their portfolio. If done right, these returns can be a safer option than their common stock counterparts. In my next article I will detail some of the secrets that only someone who has invested in these assets over time can share, plus some strategies. I hope you will continue to benefit from this series.

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