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Introduction To Preferred Stocks

October 6th, 2010 Leave a comment Go to comments

What Is A Preferred Stock?

A preferred stock is hybrid investment that has characteristics of both bonds and stocks. The easiest way to explain what they are is to say that they act like individual corporate bonds with no maturity date and trade on an exchange exactly like stocks. Bonds are investments that have a ‘par’ price and pay interest periodically (a ‘coupon’). Preferred stocks are no different. Generally speaking you invest in preferred stocks to earn interest and not to generate capital gains.

How Do They Differ From Corporate Bonds?

Corporate bonds typically do not trade on stocks markets, they trade using a unique CUSIP (actually all investments that are registered have a CUSIP, even common corporate stocks). Also, investing in corporate bonds requires buyers to make large investments in individual bonds, the minimum are typically high. Preferred stocks address this downside by making ‘slices’ of debt available at prices levels of $25 or $100. Just like stocks, an investor can buy as much or as little as he likes at these individual share price levels. Also, like corporate bonds, you are investing in a single issue bond so you can know exactly what you are buying as it is described in the accompanying prospectus.

How Do They Differ From Treasuries or Bond Funds?

The average investor buys bonds either from the U.S Treasury or by buying bond funds (As noted above, corporate bonds require large investments). U.S Treasuries are similar to corporate bonds, they pay interest and have a maturity date when all principal is returned. Preferred stocks typically have no maturity date, or if they do, it may be possible for the bond issuer to extend them.

Bonds funds are a different all together. They pool investor money to buy many different bonds with different characteristics to create a salad bar of different bonds. Preferred stocks in comparison are a single “bond” issued by the company.

Why Would A Company Issue This Stock?

Companies issue this stock for the same reasons they would issues bonds, or common stock for that matter. To raise money to make investments or pay down debt. Issuing debt allows a company to fix or know the long term cost of capital when it wants to invest in some other (presumably higher return) activity. Unlike corporate bonds, though, this stock doesn’t require the stringent credit tests that would normally be required when issuing regular corporate debt. But, preferred stocks are higher on the payout list than other kinds of debt or stock dividends (but lower than corporate bonds). So, when push comes to shove, preferred stock holders will get paid before common stocks holders.

Why Should I Invest In These Stocks?

Preferred stocks offer the ability to earn higher interest than other types of bonds, money market funds or U.S. Treasuries. They come in all types of credit quality from AAA to junk. There are many high quality companies, e.g, Con Edison (NYSE:ED), that issue these bonds and have been paying interest for decades. It’s even possible to earn returns that rival stock returns.

What Is The Risk?

Like other types of investments, including Treasury bonds, Corporate bonds, and common stocks these investments are not designed to protect principal. The benefit of Treasuries and Corporate bonds is that if you hold them to maturity you get all your principal back even if the bond itself has lost value (this loss of value would be realized if you sold it before maturity). However, preferred’s typically have no set maturity so loss of principal is possible if you sell. (If a preferred stocks ‘matures’, or is ‘called’ by the issuer, they will return the par value, even if the trading price is lower – this is similar to a typical bond maturity).

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