If you are searching for attractive yields in this low interest rate world but don't want to assume high levels of risk, preferred securities may be the solution. Like corporate bonds, preferred securities are issued by major banks, utilities, industrial corporations, and various foreign entities to raise capital. Most preferreds make fixed quarterly payments at a rate that is set when the securities are first issued. (Some newer types pay monthly.) Preferred securities have many other attractive features, including "preferred" status on payments, investment-grade ratings, affordability, and liquidity.
Why are preferred securities "preferred" by investors who are looking for relatively high yields, but want to retain relative peace of mind?
- Payments made to owners of preferred securities have preference over, or are senior to, common stocks. In other words, payments must be made to preferred security holders before dividends can be paid to common stock owners.
- The payments of most preferred securities are "cumulative." If, for any reason, preferred payments are suspended, all missed payments must be made up before any common dividends are paid.
- Common stock dividends must be suspended before any preferred securities payments can be suspended. However, preferred securities are considered subordinate to a company's senior debt, meaning that interest payments must be made to bondholders before preferred shareholders.
- Preferred status extends beyond payments. If an unforeseen disaster occurs and a company is forced to liquidate, preferred shareholders' claims on the company's assets come before common stockholders' claims. Again, however, bondholders' claims are senior to those of preferred shareholders.
- Most preferred securities are rated by Standard & Poor's and Moody's Investors Service as investment-grade quality, meaning they exhibit the strongest capacity to make payments as scheduled.
Preferred securities share characteristics of both stocks and bonds:
| Stock characteristics |
| Affordable for many investors; a good number of preferred securities trade at $25 per share. |
| Generally listed on major stock exchanges, such as the NYSE. This makes it easy to follow their prices and adds to their liquidity. |
|
| Bond characteristics |
| Relatively high fixed-rate dividend payments. |
| Interest rate-sensitive; thus, preferred securities perform more like bonds than stocks. |
|
Preferred securities generally have call features that allow the issuers to redeem them by paying a stated price after a specified date. Like bonds, preferred securities are sensitive to interest rates.
- If interest rates decline, share prices on preferreds will generally rise. As a result, the preferreds' share price could be expected to rise - possibly reaching or exceeding the call price. In that case, the company may redeem the preferred security after the call protection period expires and possibly issue new ones at a lower rate to the issuer.
- If interest rates remain the same or rise, the company is not likely to call or retire the preferred security.
- If interest rates rise, the preferred share price may drop, as investors move to higher-yielding alternatives.
If you are concerned about rising interest rates, certain types of preferred securities, such as adjustable rate preferreds, may present an attractive alternative solution.
Preferred securities fall into two categories: traditional preferreds and newer issues.
| Preferred Securities: Traditional |
| Type |
Description |
| Perpetual |
Cumulative fixed quarterly distributions; no set maturity date. |
| Adjustable Rate Preferreds (ARPs) |
Dividend resets every quarter, based on a formula tied to government bond rates. Minimum and maximum rates are set at the time of issue. |
| American Depository Receipts (ADRs) |
Represents a specified number of shares of a foreign corporation traded on a U.S. stock exchange. ADRs are issued by U.S. banks. (Remember, foreign investing is subject to certain risks, such as currency fluctuation and social and political changes. Currency fluctuation is not a factor if the securities are issued in the United States.) |
| American Depository Shares (ADSs) |
Issued by international corporations (mostly banks) that are trying to access the U.S. capital markets. Because they are issued in U.S. dollars, you do not face currency conversion risk. Dividend payments are also made in U.S. dollars. (Remember, foreign investing is subject to certain risks, such as currency fluctuation and social and political changes. This is not a factor if the securities are issued in the United States.) |
| Convertibles |
Shares can be exchanged for a specified number of common stock shares at a specified time and a specified price. Convertibles give you the opportunity to receive relatively high yields and participate in any rise in the common stock price. |
|
| Preferred Securities: Newer Issues |
| Type |
Description |
| Monthly Income Preferred Securities (MIPS) |
Issued by a special-purpose company that is created for the sole purpose of issuing preferred securities and lending the proceeds back to the parent company. They make monthly distributions, and payments are deductible by the parent company. They are not direct obligations of the parent company; however, the parent company guarantees their payments. |
| Quarterly Income Preferred Securities (QUIPS) |
Structured the same as MIPS, but distributions are paid quarterly rather than monthly. |
| Monthly Income Debt Securities (MIDS) |
Subordinated debentures that have 30- to 50-year maturities. Issued directly to investors by the parent or operating company. Monthly payments are guaranteed by the parent or operating company. |
| Quarterly Income Debt Securities (QUIDS) |
Subordinated debentures that have 30- to 50-year maturities. Issued directly to investors by the parent or operating company. Quarterly payments are guaranteed by the parent or operating company. |
| Trust Originated Preferred Securities (TOPrS) |
Issued by a special-purpose business grantor trust that exists only to issue preferred securities and lend the net sale proceeds to the parent company by purchasing a long-term debenture. Payments are quarterly. They are not direct obligations of the parent company; however, the parent company guarantees their payments. |
| Exchangeable Notes |
After an initial period and at the company's option, the notes can be exchanged or converted into the issuer's preferred stock. |
|
These newer preferred issues may have distinctive tax considerations that you should discuss with your personal tax advisor. For example, if distributions or interest payments on MIPS, QUIPS, MIDS, QUIDS, or TOPrS are suspended, accrued income must still be allocated to the investor in advance of the receipt of actual cash. This "phantom income" may result in a tax liability for income allocated but not yet received. See your tax advisor for more information.
