Investing in Preferred Stock:The Basics

Interest rates are low and the stock market is high. What is an investor to do? Isn't there a way to get higher yields with less risk? Well, the answer could be yes if you are willing to consider investing in preferred stocks.

What Is a Preferred Stock?

Preferred stocks are a hybrid security. This means they have the characteristics of both bonds and stocks. Like bonds, they pay dividends. This makes them attractive to an investor looking for income. Like stocks, preferred stocks can appreciate in value. If you are looking for an investment that straddles both of these objectives, income and growth, preferred stocks might be right for you. Preferred stocks could be an especially good choice if you are just beginning to start investing early or if you are nearing retirement. This is because preferred stocks are less volatile than common stocks. If this doesn't seem like the right investment for you, you might want to read about what savings accounts or Roth IRAs can do for you. (For more, see: A Primer on Preferred Stock.)

Interest Rate Risk

However, before we invest in preferred stocks or any kind of fixed-income investments for that matter, it is important to understand the relationship between interest rates and their value. Preferred stock prices have an inverse relationship with the movement of interest rates. This means that when interest rates decline, the price of a preferred stock is likely to rise. And when interest rates rise, the price of a preferred stock is likely to decline. Understanding this relationship is important but it doesn’t tell us everything we need to know. We also need to understand how much the price is likely to change. Is the change in price likely to be large and meaningful or is it more likely to be small and insignificant? This is where an understanding of duration can be helpful.

What Is Duration?

Duration measures the sensitivity of the price of a preferred stock or other fixed-income investments to changes in interest rates. Duration is measured in years. The higher the duration, the greater the decline you can expect in the price of your preferred stock if interest rates rise. Normally, for every 1% rise in inflation, a preferred stock's price would be expected to decline by 1% for every year of duration. The opposite would be true for a 1% decline in interest rates. If your preferred stock has a duration of 10 and interest rates decline 1%, you might expect the value of your preferred stocks to increase by 10%. Of course, the opposite would be true if rates increased by 1%.

Proceed With Caution

If you are looking for an investment that could appreciate in value and provide income, preferred stocks could be the answer. However, before you invest any money be sure to consider the direction you believe interest rates might move as well as their magnitude. Next, I recommend using a duration calculator to see how much price risk you might be taking. (For more from this author, see: The Top 3 Benefits of Investing Early.)

 

Disclosure: Prices of preferred stocks change based on interest rate fluctuations and supply and demand. As with any investment, there is default risk. Default is slightly different with preferred stocks. Most preferred stocks can delay paying their dividends/interest without being in default. Liquidity on listed preferred stocks varies. The more liquid issues may have as little as a few pennies difference between the buy price and the sell price. Some less popular issues may trade with as much as a full dollar difference. Most preferred stocks are callable. Before buying a preferred, investors should find out the 'yield to first call' or 'yield to worst' on the preferred they are considering.

The views expressed in the cited and linked articles are not necessarily the opinion of First Allied Securities, Inc., and should not be construed as a substitute for professional guidance in tax, estate planning or legal matters. This also does not constitute an offer to purchase a particular investment. Individual authors cited here are not affiliated with First Allied Securities, Inc.

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