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I have received many questions about preferred stocks - "Are they a good investment? What are the risks? Should I have them in my portfolio? Are they the same as bonds?" I would like to take some time and expand on preferred stocks and provide a little education, at the same time present a situation where they may have room in your portfolio. As always, you must decide if these investments vehicles meet your investment goals, needs and risks. When we talk about investments, we focus on long-term opportunities and not day trading or options to churn money in the market. That is a way to invest, but many investors don't have the knowledge or skills to make money this way. We recommend investments that we believe you can buy and hold long term.

Preferred Stocks Are:

A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights.

Preferreds are issued with a par value (face value) and pay dividends based on a percentage of that par at a fixed rate. Just like bonds, which also make fixed payments, the market of preferred shares is sensitive to changes in interest rates. If interest rates rise, the value of the preferred shares would need to fall to offer investors a better rate. If rates fall, the opposite would hold true. However, the relative move of preferred yields is usually less dramatic than that of bonds.

Preferreds generally have an unlimited life because most, but not all, have no fixed maturity date. They may have a call date, which is a date set in the prospectus, which can be called by the issuer after a certain date. The motivation for the redemption is generally the same as for bonds; a company calls securities that pay higher rates than what the market is currently offering. Also, as is the case with bonds, the redemption price may be at a premium to par to enhance the preferred's initial marketability.

Like bonds, preferreds are senior to common stock. However, bonds have more seniority than preferreds. The seniority of preferreds applies to both the distribution of corporate earnings (as dividends) and the liquidation of proceeds in case of bankruptcy. With preferreds, the investor is standing closer to the front of the line for payment than common shareholders.

As with convertible bonds, preferreds can often be converted into the common stock of the issuing company. This feature gives investors flexibility, allowing them to lock in the fixed return from the preferred dividends and, potentially, to participate in the capital appreciation of the common stock.

Preferreds pay dividends. These are fixed dividends, normally for the life of the stock, but they must be declared by the company's board of directors. As such, there is not the same array of guarantees that are afforded to bondholders. This is because bonds are issued with the protection of an indenture. With preferred stock, if a company has a cash problem, the board of directors can decide to withhold preferred dividends. The trust indenture prevents companies from taking the same action on bonds. Another difference is that preferred dividends are paid from the company's after-tax profits, while bond interest is paid before taxes. This factor makes it more expensive for the issuing company to issue and pay dividends on preferred stocks.

I am not a fan, like the general market is, for computing current yields on preferred stock or bonds. The process for the calculation is the same by dividing the annualized dividend by the stock price to get the yield. This can be done for common stocks, preferred stocks and bonds. I tend to recommend the long-term approach and look at the purchase of preferred as a one-time cost, and focus on the stated return in the prospectus as an income producing vehicle.

For example, per the prospectus, a preferred stock is set to pay an annualized dividend of $1.75 and its issue price was $25, the yield is: $1.75/$25 = 7%. If you are purchasing preferreds in the after market, and buy for let's say $20.00, you will still get the dividends of $1.75. On paper, you can claim a higher return ($1.75/$20 = 8.75%), but you still only get the $1.75 dividend. I like to focus on the dividend, the per share, per pay period amount paid to me. I can take this out to live on without reducing my position, or use the return to reinvest.

Preferreds have fixed dividends and, although they are never guaranteed, the issuer has a greater obligation to pay them. Common stock dividends, if they exist at all, are paid after the company's obligations to all preferred stockholders have been satisfied.

Cumulative: Most preferred stock is cumulative, meaning that if the company withholds part, or all, of the expected dividends, these are considered dividends in arrears and must be paid before any other dividends. Preferred stock that doesn't carry the cumulative feature is called straight, or noncumulative, preferred.

Callable: The majority of preferred shares are redeemable, giving the issuer the right to redeem the stock on a date or after, with the board's decision, and the price and terms specified in the prospectus.

Convertible: Preferred stock may have a conversion process in the prospectus. This spells out when (usually after a certain date), and what are the terms. The board will decide if and when to execute, but the conversion price is clearly spelled out in the preferred stock's prospectus.

Participating: Preferred stock has a fixed dividend rate. If the company issues participating preferred stocks, those stocks gain the potential to share more of the company's profits than their stated rate. The exact formula for participation will be found in the prospectus. Most preferreds are non-participating.

Adjustable-Rate Preferred Stock (ARPS): These relatively recent additions to the spectrum pay dividends based on several factors stipulated by the company. Dividends for ARPSs are keyed to yields on U.S. government issues, providing the investor limited protection against adverse interest rate markets. Many investors will shy away from adjustable rates because they come to preferred stock to lock in a return. Those interested in adjustable rates may be better served with common stock because the upside is much higher. ARPS are new and will have to establish a track record in the market for many investors to buy in to the concept of adjustable preferred stocks.

Preferred Stocks Pros

  • Higher fixed-income payments than bonds or common stock
  • Lower investment per share compared to bonds
  • Priority over common stocks for dividends payments and liquidation proceeds
  • Greater price stability than common stocks
  • Greater liquidity than corporate bonds of similar quality

Preferred Stock Cons

  • Callable
  • Lack of specific maturity date makes recovery of invested principal uncertain
  • Limited appreciation potential
  • Interest rate sensitivity
  • Lack of voting rights

Here is a list of several Preferred Stocks I like

ARMOUR Residential REIT Inc. (NYSE: ARR) has 2 preferred shares, I will discuss the series A here. ARR.PRA is the symbol. The initial/face price was $25.00 and as of December 16, 2013 is trading at $20.9999. The preferred shares are redeemable, perpetual and cumulative. It pays a monthly dividend of $0.1719 for an annual dividend of $2.0625. The base yield is 8.25%.

GreenHunter Resource Inc. (AMEX: GRH) has a preferred stock I want to share. GRH.PRC has a current price of $19.40 with an initial face value of $25.00. A good buy with a dividend of $2.71 for the year, 10.875% that pays quarterly. This preferred stock is redeemable, perpetual and cumulative. The call date on this is June 30, 2015. If the company chooses to buy it all back, you would receive $25.00 per share.

Citigroup Inc. (NYSE: C) has many preferred shares, and I will highlight C.PRW as another preferred to discuss differences in the shares. This stock is trading at a premium of $25.05 over the initial price of $25.00. The stock is redeemable and cumulative, but is not perpetual with an end date of December 31, 2066. The dividend is paid quarterly at $0.40 for an annual pay of $1.60 and 6.45%. Notice the much lower return from a much larger and more valued company. Many of the blue chip stocks will have a lower return on their preferred stocks.

Others

ARR.PRA - 8.25% base yield

ARR.PRB - 7.85% base yield

ANGCP - 8% base yield

C.PRW - 6.45% base yield

C.PRC - 5.8% base yield

GRH.PRC - 10% base yield

ADK.PRA - 10.875% base yield

SPPRP - 8% base yield

SPPRO - 10% base yield

SAN.PRB - floating rate, non-cumulative, heavily discounted from face value, paid quarterly.

BML.PRH - floating rate, non-cumulative, perpetual, paid quarterly. Currently discounted 34%. $25.00 face value with current market price of $16.89.

The Bottom Line

An individual investor looking into preferred stocks should carefully examine both their advantages and drawbacks. There are a number of strong companies in stable industries that issue preferred stocks that pay dividends above investment-grade bonds. If you're looking for relatively safe returns, you shouldn't overlook the preferred stock market. Information about a company's preferred shares is easy to access. Using many of the stock search programs you normally use and viewing the company's direct website allows you access to the prospectus of many preferred stocks. With the information above you can begin researching to find the investments best for you. The low par values of the preferred shares (many at $25 per share) make investing easier, because bonds, with par values around $1,000, often have minimum purchase amounts (i.e. five bonds).

Source: Where Preferred Stocks Fit In My Portfolio

Additional disclosure: I also have positions in ARR.PRA, SPPRO.