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What About Preferred Stocks?

Summary

Why Preferred stocks are “preferred” over common stocks?

About the "debt" components of Preferred stocks

Why do companies chose Preferred stocks over bonds?

Why Preferred stock Yields are typically higher?

About the Benefits of investing in Preferred stocks

The Preferred stock arena continues to offer great opportunities. A smart strategy, investing safely in Preferred stocks, could conservatively target a 6 to 12% annual return basis while bearing extremely low-risks. It would consist in capturing intrinsically high yields while maintaining interest rate, credit and market risks to a strict minimum.

The following is a preliminary discussion of the big picture fundamentals.

1) Fundamentals

Why Preferred stocks are “preferred” over common stocks? 

As the name suggests, preferred stocks have some preferences over common stocks:

  • If a company is to be liquidated, preferred stockholders have priority over common stockholders
  • If a company does not have enough earnings in a period to pay dividends to both the preferred and the common stockholders, those with preferred stocks will be paid first

However, preferred stocks behave more like hybrid securities, between common stocks and debt securities.

About the "debt" components of Preferred Stocks

  • Preferred stocks are issued at par (face value of the security)
  • Dividends are paid in cash on a semi-annually, quarterly or monthly basis
  • Preferred stocks are typically reimbursed at par value (plus accrued dividends when a cumulative dividend covenant is included)

However, most preferred stocks have no maturity date, and thus are perpetual fixed or floating rate securities.

New issues typically carry a 5-year call protection which allows the company to cancel and reimburse shareholders at a date of its convenience past a period of 5 years.

Why do companies chose Preferred stocks over bonds? 

Companies use preferred stocks instead of bonds essentially because :

  • Companies can decide when to reimburse, instead of being bound to reimburse at a predefined future date (maturity date). Basically, preferred stocks pay perpetual dividends until the company decides to cancel and reimburse its shareholders. However, the company cannot do this before a predefined “Call date”, typically 5 years passed the issuance date.
  • Companies can differ the payment of a dividend without triggering a default (unlike bonds): dividends are declared by the Board of Directors which reserves the right to defer them (although it must pay it at a later date when cumulative)

Why Preferred stock Yields are typically higher? 

Preferred stocks have typically higher dividend yields to compensate for the fact that:

  • Preferred shares rank junior to the company's senior debt and get paid behind bondholders in the event of bankruptcy
  • Preferred stocks offer intrinsically less potential of capital appreciation or depreciation than common stocks and are less correlated to the company's earnings than common stocks

About the Benefits of investing in Preferred stocks 

  • Preferred stocks are listed securities (primarily on the NYSE), unlike Bonds which often lack of a centralized exchange system
  • Preferred stocks pay a fixed (or floating) dividend rate (the equivalent of a bond coupon)
  • In many cases, its dividend is cumulative, requiring that if a company fails to pay a dividend, it must pay it later, on a cumulative basis, and in any cases prior to any new payment of dividends made to common stockholders
  • Yields are by nature higher than common stocks and bonds
  • Preferred stock prices are less volatile than common stock prices and less affected by the company's "health" than common stocks: investors are therefore less exposed to potential capital losses.

2) Beating PFF

The below is a quick glimpse at future discussions:

  • "PFF", the Preferred stock index
  • High Yield Callable Preferred stocks
  • Credit Protected High Yield Preferred stocks
  • Initial Public Offerings of Preferred stocks
  • Arbitrages of Preferred stocks

[To be continued]

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Fontainebleau Capital is a private investment manager that primarily invests in discretionary long-short equities and makes significant quantitative and macro investments. As a private investment manager, Fontainebleau Capital does not provide access to information about products and services to the general public for regulatory reasons.