Preferred Stocks: Everything Retirement Savers Need to Know
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm talking about preferred stocks after receiving a great question from one of our listeners, Jean, in Kansas earlier this year. Specifically, Jean was looking for a way to get better returns on bonds and cash and asked if preferred stocks would be appropriate.

In addition to answering Jean's question, I'm also breaking down what preferred stocks are, why you would invest in them, and little known risks to watch out for. So if you're ready to learn all about preferred stocks in plain English, today's episode is for you. For the links and resources mentioned, head over to youstaywealthy.com/130.

When a company becomes insolvent and can't pay its obligations, they go through a process known as liquidation. And when a company is liquidated here in the United States, its creditors, i.e. the people they owe money to, are paid in a particular order.

Keeping it simple for today, bondholders are paid first, then preferred stockholders, and then common stockholders. We're of course going to be talking a lot more about preferred stockholders today, but really quick, common stockholders are what most of you are familiar with. Common stockholders are those investors who simply buy and own stock of a company. The stocks and ticker symbols talked about all day on CNBC.

When you buy shares of a common stock like Apple or Google or Facebook, let's say, you have a small slice of ownership in that company. And while you are an owner, you're actually at the bottom of the list to receive whatever assets remain during a liquidation event. And that's one of the benefits often highlighted by preferred stock advocates. Yes, they get paid after bondholders, but their claim on assets is greater than common stockholders.

They also have priority over common stockholders when it comes to distributions like dividends.

So what is a preferred stock? Let's start there. In short, a preferred stock is often referred to as a hybrid security because it has characteristics of both bonds and common stocks. Like common stocks, they represent ownership interest in a company. And like bonds, they usually pay regular interest payments or dividends based on the face value of the security.

Also, like a bond, they carry a credit rating from a rating agency. The higher the credit rating, the lower the risk. Also, the lower the yield and return. Remember, you can't have your cake and eat it too. While a company like Wells Fargo, let's say, can issue both bonds and preferred stocks, their preferred stock will typically be rated a little lower than their bonds, given that preferred stocks contain more risk.

Another important characteristic is that preferred stocks usually have really long maturities, like 30 years or longer, and sometimes no maturity at all. Most of them are also known as what's called callable, which means a company like Wells Fargo can take your shares back from you at a set price before the stated maturity date.

You might be wondering why I randomly chose Wells Fargo as an example here. Well, interestingly enough, the big blue chip companies that we all know by name don't issue preferred stock. In fact, out of the 30 largest companies in America, there are only four that offer preferred stock. Those are Wells Fargo, Bank of America, Citigroup, and JP Morgan. You're probably picking up on the fact that those are all banks, and that's who makes up the majority of preferred stock issuers.

88% of preferred stock is issued by banks, mostly as a result of the financial crisis and corresponding bailouts in 2008 and 2009. So really quick to recap where we're at so far. Preferred stocks are kind of like a stock and kind of like a bond. They're a hybrid. They have a credit rating. They have very long maturities, sometimes none at all. And they are mostly issued by banks. So why would someone want to buy preferred stocks?

According to Charles Schwab, preferred stocks are designed to provide steady income through quarterly interest or dividend payments, and their yields tend to be higher than those of other traditional fixed income investments. Also, preferred stocks are traded on a stock exchange, so there is greater price transparency.

To summarize all that in plain English, people buy preferred stocks to get more income than they're getting from their bonds and cash. Back to Gene's question.

But just because they pay higher yields and provide more income doesn't necessarily mean they should be used as a bond or cash substitute. As I alluded to earlier, and as mentioned all the time on this show, return and risk go hand in hand. There's no such thing as low risk, high return. If something is paying a higher yield or delivering a higher return, it contains a higher amount of risk.

As my dad always said and still says, if it sounds too good to be true, it probably is. And I'm not saying that preferreds are bad necessarily, but the risk should be properly taken into consideration.

So let's break this down a little bit more. Just how much higher of a yield might you expect from preferred stocks? Well, according to Morningstar, as of September 30th of 2020, the average SEC yield for preferred stocks was about 5%. At the same time, dividend paying common stocks were yielding about 2% and intermediate bonds were paying about 1%.

While 5% sounds pretty appealing, one very important thing to note is that preferred stock dividends aren't considered debt obligations. Issuers are allowed to defer dividend payments. Now, missed payments are allowed and they don't cause the company to be considered indebted

in default. However, missed or deferred payments to preferred stockholders like you mean you don't get your retirement paycheck that month or that quarter. Not very ideal for someone relying on that income. But to put that risk into perspective and to be fair here, only about 6% of preferred stock issuers defer or cancel dividend payments over a 10 year time period.

That doesn't mean it doesn't happen though. In fact, you might remember from last year, Chesapeake Energy declared voluntary bankruptcy and the preferred shareholders were not able to recover anything. One solution to reduce the risk of missing a dividend payment or worse, losing your entire investment altogether like those Chesapeake Energy investors is to purchase a preferred stock mutual fund or exchange traded fund.

This is certainly an improvement, but as shared earlier, most preferred stocks are banks, so these so-called diversified funds still end up being pretty highly concentrated.

Another risk, which is probably the most important to take note of, is that preferred stocks end up behaving more like common stocks during market downturns. In 2008, preferred stocks dropped just over 25%. And last year, during the COVID crash, when the stock market dropped about 34%, preferred stocks were down close to 23%.

And that right there should tell you that they are absolutely not a bond or cash alternative. The last thing we want during a catastrophic time period is for everything in our portfolio to start behaving like stocks, especially our bonds or our bond alternatives.

Even further, preferred stocks have proven to be just about as volatile as common stocks over the last 15 years. But get this, they provided investors with less than half the return. According to Morningstar, preferred stocks had a 15-year average annual rate of return of 4%, while the S&P 500 returned just over 9% each year during that same time period.

Preferred stocks also underperformed intermediate bonds during the last 15 years, which returned 4.5% on average. So you took more risk than bonds and earned a lower return. You also accepted a similar amount of volatility to stocks and you earned a much lower return. Now, to be fair, 15 years is a short time period and the next 15 years could look much different than the previous.

Due to their higher than average risk profile, preferred stocks could certainly surprise investors on the upside. But I would still expect them to behave like common stocks when things get ugly. For that reason, when it comes to using preferred stocks as a bond or cash alternative, I'm out.

Now two quick things before we part ways today in an effort to prevent hate mail from the preferred stock evangelists here. Number one, over the last 10 years, preferred stocks have actually been weakly correlated to US common stocks. They've had a correlation coefficient of 0.59 for all those finance nerds out there.

But in plain English, over the last 10 years, preferreds really haven't moved in lockstep with US stocks and therefore have helped add diversification to a stock portfolio and reduce overall risk a little bit. Again, short timeframe and you still suffered negative double digits during a catastrophic time period, but something to take into consideration and put into the pro column.

Number two, lastly, I want to make sure to note that preferred stocks do typically have preferential tax treatment when compared to bonds. Most preferred stock dividends are considered qualified and are taxed as long-term capital gains, whereas bond interest payments are taxed as ordinary income.

The key word there is qualified. So you would want to verify that with your custodian or financial advisor before making the assumption about the tax treatment of any preferreds that you might own or any that you're looking to buy.

For all the links and resources mentioned today, head over to youstaywealthy.com forward slash 130. Thank you as always for listening, and I will see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.