Is Preferred Stock Safe?

A reader writes in to ask,

I left my broker recently after learning about the importance of expenses. I transferred my IRAs to low-cost index funds, and I plan on liquidating most of my taxable account to pay down my mortgage. But much of the account is in preferred securities, and I don’t fully understand how they work.

The broker said that they’re basically a hybrid security which is part equity and part fixed income. Are these relatively safe from market conditions? In other words, could they dramatically fall in value if the market goes south, or do they work more like CDs? One of them has a fixed coupon rate of 8%. Does that have anything to do with how much I’ll earn?

If these preferreds guarantee me a return for a certain period of time, then I’d hold onto them a little longer. But if they can dramatically drop just like stocks can, then I’ll probably just sell them.

Your former advisor was correct that preferred stock is somewhere between bonds and normal (“common”) stocks.

The idea of preferred stock is that dividends (based on the preferred stock’s stated coupon rate) must be paid to preferred stockholders before any dividends can be paid to common stockholders.

And because preferred stock typically has a much higher yield than common stock, it’s thought to be an “income” investment, much like a bond.

But Nothing is Guaranteed

But to be clear, nothing is guaranteed with preferred stocks. They are nowhere near as safe as CDs.

The dividend payment is not guaranteed. If the company chooses not to pay dividends to common stockholders, they don’t have to pay dividends to preferred shareholders either. (Though if the preferred stock is “cumulative preferred stock,” there is a slightly higher degree of protection because the company would have to pay dividends in arrears to make up for each of the missed preferred dividend payments before any dividend can be paid to common shareholders.)

And the market value isn’t guaranteed either. For example, the following chart from Morningstar plots the price of iShares S&P U.S. Preferred Stock Index Fund (PFF, in blue) against the price of Vanguard Total Stock Market ETF (VTI, in yellow) from 3/30/2007 through 4/2/2012. As you can see, preferred stocks can lose market value just like common stocks.

Finally, if a company goes out of business, shares of its preferred stock are considered an equity position rather than a creditor position — meaning all creditors would have to get every dime they’re owed before preferred stockholders would get anything.

In short, preferred stocks have a high yield — making them bond-esque investments in that regard. And if everything is going well and the company is paying dividends, a preferred stock will have a predictable rate of return. But nothing is guaranteed — neither the dividend payment, nor the market value of the stock.