The Disadvantages of Preferred Shares

At first glance, preferred stocks seem like a great deal. They usually pay relatively high fixed dividends and, if the company fails, owners of preferred shares get their money back before common stockholders. If this seems too good to be true, your instincts are on track. These hybrid securities have features that may pose a significant disadvantage relative to other investment options.

Static Dividends

Issuers of preferred stocks set the dividend rate at the time of sale, and this rate remains the same until the stock matures, usually 30 years. The dividend, also called the coupon rate, is usually higher than prevailing bond interest rates, so it seems like a really good deal at the time of purchase. But if interest rates go up, your locked-in dividend rate could be significantly less than the interest you could have earned with a bond; with bonds, the interest rate fluctuates with the market.

Limited Increase in Value

The share price of preferred stock usually remains fairly steady, so you have little chance of profiting from an increase in share value when you sell the stock. In fact, if interest rates increase, the value of your shares will decrease because investors are more interested in higher yielding bonds. They won't be willing to pay as much for a stock with lower dividend rates.

Insolvency Risk

Preferred stocks are a mechanism for raising capital, so issuers normally are startup companies or firms undertaking an expansion. The risk of insolvency is greater with such companies than with a well-established firm. If a company must liquidate, bondholders receive payments first, then preferred stockholders; the remainder, if any, goes to common stockholders. You likely would receive some recompense in the event of a bankruptcy, but you may not recuperate the full amount of your initial investment. In addition, companies sometimes withhold preferred stock dividends when they are moving toward bankruptcy.

The Risk of a Share Call

Most preferred stocks come with a call date -- typically five years after the date of issue. After this date, the issuer has the right to call in outstanding preferred stocks and buy them out. Declining interest rates are usually the reason behind this move. For example, if you purchase shares with a 4 percent dividend and interest rates drop to 2 percent, the issuer may call in your shares, pay you the current market price and then reissue the shares with a 2 percent dividend, which will save the company a significant amount in debt service costs.

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