How to Invest in Preferred Stocks The Hidden Investment (Part I of a Series)

The market crash of 2008 made people reconsider the amount of risk they were comfortable taking with their retirement and personal investment accounts. Many people had a harrowing journey that saw their life savings drop precipitously. My own personal nightmare saw my retirement account drop by 55% within six months. Everyone seems to be looking for a way to cut down on risk, yet still achieve a respectable return that will allow them to build enough for a comfortable retirement.

As I have stated before, I obsessively read everything personal finance. My favorite website is Marketwatch which is put out by the Wall Street Journal. There are countless columnists who regularly put out articles on everything from investing to spending to retirement and Social Security. I troll the internet for anything that will help me make better decisions relating to my money and future.

What is amazing to me in this age of caution is that in all the articles on the internet very few ever mention what I personally consider one of the best kept secrets of investing for the average guy- preferred stocks. Most people do not understand the difference between a regular stock and a preferred stock, nor how to invest in them. See below a section that always appears on Marketwatch. If you look at the categories, preferreds are not even listed. If you drill down on the 'How to buy stocks' option there isn't a mention on the differentiation between the two types of stock.

I will point out right away that investing in preferred stocks requires some education on the subject along with a very good understanding of math. While it is not as complicated as annuities or options, learning about preferreds can be well worth your time.

First off, a basic definition of what they are. A Preferred stock can best be described as a mix between a common stock and a corporate bond. They are offered by companies in order to raise funds- possibly for expansion, maybe investment, or even debt repayment. These issues have a face value which is the initial cost in which they are offered for. Once the initial sale is done the price can fluctuate below or above that value. The advantage of these issues is that payment of the stock holds precedence over any dividends or repayment that would be given to common stockholders.

The value of the stock does not usually fluctuate much, although there are situations where they do such as during interest rate changes which I will explain further later in this article. You do not invest in these issues for share appreciation, but rather for the regular dividends they provide.

Before going further here is some basic terminology that I will reference going forward:

Face Value/Issue Price: The value of the stock at initial offering. Usually they are issued in $25 increments, but values such as $50, $100, or even $1000 are also common.

Coupon Rate: This is the amount of interest the preferred stock will pay annually. Rates vary based on many factors. The more financially stable the company, the lower they can pay in interest to convince people to buy their offerings.

Call Date: This is a date in which the company has the right to buy back all the outstanding shares at the issue price of the stock. So if the face value was $25 and the call date is 1/1/2015, on that date they may "call in" the issue by giving you $25/share and make the stock defunct. That does not mean they will do that, it only gives them to the right to.

Maturity Date: The date the company MUST call in all the shares. Not all issues have maturity dates but ones that do hold a special advantage that we will discuss in later articles.

Rating: This is a score given by the ratings agencies to judge the financial stability of the company. A+ or AAA is tops and ratings go down from there. Some issues do not have a rating because the company did not pay to obtain this.

Distribution Dates/Frequency: Most issues pay interest on a quarterly basis, or four times a year. Others do monthly, semi-annually or annually.

Cumulative/Non-Cumulative Dividends: Sometimes a preferred stock company will miss a dividend payment. If the stock is cumulative the company is required to catch up on that missed dividend when the next one is paid. If non-cumulative they do not have to pay the missed amount.

Ex-Dividend Date: The date in which you must own the stock in order to claim the dividend for that period. Very important for the buy and sell investor.

Record Date: The date in which the company notes the owners of the preferred and sets up dividend distributions.

Distribution Date: The date in which a stock holder will receive their dividend

The benefits of investing in Preferred Stocks are numerous.

First off, they are less volatile than regular stocks. They fluctuate but in a more predictable manner. The share price will drop on the ex-dividend date by the amount of the dividend payment. So if an issue pays a .50 dividend every quarter and the stock is selling at $25 it will drop to $24.50 the day of market close on ex-dividend day. It will frequently gain value back the next day at open. Rarely do issues stay at that amount for long with most gaining back that amount before the next ex-dividend date.

Secondly, if a company is in financial trouble they are obligated to pay preferred stock shareholders before those who hold common stock. You are in the front of the line for repayment. Most companies are also required to pay preferred stock dividends before a common stock dividend of any amount can be paid.

Third, the dividends they pay overall are much better than one would be able to get in a money market, CD, or high quality bond. While they fluctuate, it is not uncommon to find issues that pay between 5% and up past 10%.

Fourth, they throw off a lot of income in the form of dividends. For an income investor they are a valuable asset. If purchased and reinvested, the compound interest can add up quickly.

With reward there always come risks, and there are a few that must be mentioned.

First, because they share a common trait with bonds they are very sensitive to interest rates. In a rising interest rate environment they will lose share value. The dividends will stay the same, but the shares will always go down in price. The reason is that safer investments such as money market funds, certificates of deposit, and regular bank savings accounts will now pay a higher rate of interest. That means more people will now accept this return and in turn move out of a riskier investment. This decline in share price can be roughly calculated by taking the interest rate hike percentage away from the share price.

Second, dividends can become suspended at any point if the company is having financial difficulty. This is where ratings from companies such as Moody's and S&P come in. They will judge the likelihood that such an event will happen based on the company financials. It is rarely in a companies self interest to suspend payment because of investor goodwill. Making sure you invest in cumulative issues helps in that when the company starts paying again they will have to make up the missed dividends.

Third, based on the issues you invest in you can rely on a smaller annual return in boom times. Getting 7% a year sounds good in a down market, but when the general market returns over 30% as in 2013 it doesn't seem as great. However, the up and down nature of markets shows that over time an investor rarely achieves over 8% a year due to fees and basic investor psychology. If that is what you will most likely get in the end, why wouldn't you take a safer more predictable path?

Now that you understand what Preferred Stocks are, it is time to learn how you can invest in these to your advantage. There are many strategies to investing in preferreds and I hope to provide more articles over time to help you take advantage of this type of investment. Please come back to read more. Everything I write will be based on personal experience on where I have succeeded and where at times I have failed.