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. Preferred stock disadvantages often outweigh the privileges of preferred stock. Investors need to weigh the pros and cons of preferred stock to determine if these hybrid securities are a better choice than other investment options.
Fixed Dividend Rate
Issuers of preferred stocks set the dividend rate at the time of sale, and this rate remains the same until the stock matures, often 30 years. The dividend, also called the coupon rate, is usually higher than prevailing bond interest rates, so it may seem like a really good deal at the time of purchase.
But your locked-in dividend rate creates interest rate risk. If market interest rates rise, the price of your preferred stock will fall because other investments will become more attractive. For example, if you buy a preferred yielding 4 percent and market rates rise to 6 percent, investors will sell your preferred to buy the current, higher-yielding option.
Limited Appreciation Potential
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 investments, and they won't be willing to pay as much for a stock with lower dividend rates.
Unlike common stock, which typically rises when the underlying company reports rising profits, preferred stock values are almost entirely dependent on current market interest rates. This is because preferred stock doesn't represent ownership in a company, like common stock. Rather, a preferred stock is a debt obligation issued by a company.
Risk of Corporate Insolvency
Preferred stocks are a mechanism for raising capital, so issuers are often 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, as bond holders are higher up in the corporate food chain. In addition, companies sometimes withhold preferred stock dividends when they are moving toward bankruptcy.
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.
If you want to reinvest your money at that time, you'll be stuck with the new, lower 2 percent rate instead of the 4 percent dividend you were accustomed to earning. A call date puts all the power in the hands of the issuing company, and there's nothing a shareholder can do about it.
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