An Introduction To Preferred Shares by Eli Inkrot, Sure Dividend

Lately I’ve been demonstrating different ways to supplement your dividend income.

For instance, this can be done on the ownership side by selling covered calls or on the buying side by selling cash-secured puts.

Neither of these methods are for everyone. Making these sorts of agreements brings an added layer of complexity that may not be worth it for your typical buy-and-hold, “set it and forget it” type of investor.

Yet for those looking to increase their cash flow, these two methods are certainly worthy of consideration.

Today I’d like to talk about a third avenue for finding an above average cash flow stream: preferred shares.

An Introduction To Preferred Shares

Once again, this isn’t necessarily a recommendation, but more a means by which to gain awareness of an additional investment possibility. In detailing this possibility, I’d like to keep it straightforward; you can always get more complicated, but it can be hard to get back to the basics.

What Is A Preferred Share?

A preferred share (or stock) is technically an equity stake in a business, but it shares characteristics of what you would find with both equity and bonds.

The equity part is that it has an underlying claim on the business and you collect dividends. The bond-like portion is that the dividends that you receive are fixed payments.

What’s So Preferential About Preferred Shares?

Good question. Here’s a look at the basic corporate capital structure:

Preferred Shares

Source: Market Realist

In the event of bankruptcy or liquidation, preferred equity ranks below debt but above the common equity shares of a company.

The risk that the above chart is talking about relates to the likelihood of being paid back in the event of an adverse circumstance. With an ongoing, profitable business such as Coca-Cola (KO) or U.S. Bancorp (USB) all of these components are satisfied completely.

The potential returns associated with each segment is generally opposite of what you see above.That is, common equity generally has a higher expected return as compared to debt in the long run.

This doesn’t always have to hold, but it’s generally the case.

Note:  Many preferred shares are found in the financial (banks and REITs) or “fixed asset” business like utilities, so your typical dividend growth company may not issue preferred shares are all.

You likely don’t own preferred shares for their slight protection in the event of bankruptcy. While your claim might be greater than the common shares, it could still be quite low.

The true benefit of being “preferential,” in my view, is that this means that the dividend payments are preferential as well.

In order for a company to pay its common dividends it must first satisfy its preferred dividends (if applicable) in full. This has an important ramification in poor but not devastating times.

For instance, during the Great Recession Wells Fargo (WFC) was forced to cut its common dividend from $0.34 per quarter to just $0.05. For the common equity holder this was a large blow to your annual income, and an event that you would have not recovered from, income-wise, for many years.

Things turned out differently for the investor who owned preferred shares in Wells Fargo. Because the company was still paying a common dividend – albeit a significantly reduced one – that meant that Wells Fargo had to first satisfy its preferred dividends in full. So the preferred share owner who was collecting a say 6% annual preferred dividend, kept on receiving their full payments. The preferential nature provided a benefit in this instance.

Basic Features of Preferred Shares

For this section I’d like to talk about some basic features that you might run across as you learn more about preferred shares.

Basic Feature #1:  Preferential Dividend

This aspect was just talked about, but it’s worth repeating as this could be the second largest draw of owning preferred shares.

If a common dividend is being paid – regardless if its 50% higher or lower than it was (even if only a penny) – the preferred dividends are being paid in full.

Basic Feature #2:  Fixed Payments (More Common)

Often preferred shares come with a fixed rate that will be paid in perpetuity.  So as an example, a preferred share might have a 6% yield that will be paid every year.

The advantage, and sometimes largest draw, is the above average dividend yield. The disadvantage is that this payment will not be increased.  This is quite unlike what many dividend growth investors have come to expect for their payouts over the years.

Basic Feature #3:  Floating Payments (Less Common)

Although a fixed payment is common, you can also have floating rate preferreds.

These securities either start with a floating rate, or have a fixed rate for a time before switching over to a floating rate. The rate is often based on a well-known benchmark such as LIBOR.

Basic Feature #4:  Lack of Voting Rights

Generally preferred shares do not have voting rights, like common equity does. This likely doesn’t make a difference for the small investor, but it is a reason why management may prefer to issue these shares instead of common ones (among other reasons).

Basic Feature #5:  Cumulative vs. Non-Cumulative

Preferred shares can either be “cumulative” or “non-cumulative.”

If a preferred share is “cumulative,” this means that if the company were to miss or not pay any preferred dividends then they would have to make up those missed payments before reinstating the common dividend. A lot of investors look for this feature, but really you don’t want it to get to that situation. You’d much prefer the company to continue paying dividends on the common shares and not to have to worry about the company paying you back later.

Basic Feature #6:  Perpetual

Unlike most bonds, preferred stock can be outstanding forever, or as long as the company is around.

Basic Feature #7:  Callable

While the preferred shares may not have an expiration date, they could be “callable.”

This means that the company has the option to redeem the shares at a certain price after a date in the future.

So for instance, a company might issue perpetual preferred shares in 2016 with a call date in 2021. This means that if you bought these shares you’d receive your dividend payments (presuming they are being paid) for the first five years at least. Thereafter it’s at the company’s discretion whether or not it wants to keep the preferred shares outstanding or to buy them back.

A company might reissue new preferred shares and redeem the outstanding ones if rates decrease in the future. As an example, if a company has preferred shares paying 8% outstanding and can now sell 6% preferred shares, it could issue new shares at 6% and buy back your 8% shares. There are some special circumstances, but generally this can only be done if it’s after the call date.

So in keeping with the example, you might be able to hold the shares for 5 years or 100 years, depending on the prevailing rates and what the company wants to do.

Basic Feature #8:  Liquidation Preference

You’re probably asking, “what is this ‘certain price?’”

The price at which a company can buy back the preferred

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