During market unrest, preferred stocks can offer smoother returns.
Typically issued by banks, real estate investment trusts, and utilities, preferred stocks usually pay a fixed rate of dividends. That makes them similar to bonds, which usually pay a set dollar amount of interest. Payments are usually quarterly, better than for bonds, which typically pay just twice a year. Issuers of preferred securities give preference over holders of common stock when paying out the dividends. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
Before any company issuing them reduces dividends, it must first ax those paid on common stock. Any such decision of course can affect the company’s credit rating. Consequently most companies issuing these securities rarely reduce the dividend paid on preferred classes of their shares.
So, if these stocks are harder to understand, why consider them? There are several reasons why investors should give these a closer look. One: preferred stocks generally yield more than a company’s common stock and sometimes yield more than the firm’s bonds. In addition, dividends from some preferred stocks are qualified, meaning that they are taxed at a top federal tax rate of 23.8%*. Non-qualified dividends are taxed at a maximum federal rate of 43.4%*. For this reason, it’s best to use non-qualified preferreds inside of tax-deferred accounts, such as IRAs.
Two: in the context of current market volatility, preferred stocks can be less risky. That is, they oscillate less in value day to day than do common stocks. Of course, bonds – that is, actual bonds, not the mutual fund or ETF forms- can move around even less as they are not as actively traded by retail investors. Therefore, they usually don’t exhibit the wild swings that the equities market may on a particularly volatile day.
However, rising interest rates can reprice preferred stocks downward below their par values, raising the current yields for new buyers. Existing shareholders would be holding discounted valuations until redemption. For this reason, inflation and rising interest rates are risk factors. Because preferreds pay fixed dividends, higher rates could force down preferred share prices.