Investing Questions and Answers: Are Preferred Stocks Good Investments?

Several readers have emailed in questions about investing in general. Instead of sending a direct answer, all the readers would benefit from seeing the questions that were asked along with the answers. This will hopefully become a regular weekly feature.

I noticed that the preferred stocks of companies I have an interest in pay a higher dividend yield than the common stock. As an income investor, shouldn't I be just buying preferred stocks?

First, let's review the difference between common stock and preferred stock. Common stock shareholders participate in the growth of the company. Dividends are not guaranteed; they can be eliminated, reduced, or increased. The price of the stock can fluctuate for numerous reasons. In the event the company goes out of business, the common stock shareholders are the last ones to be paid off, after the bond holders, then the preferred stockholders, assuming there is anything left.

Preferred stocks are basically income investments. They pay a fixed income and unless there is a major issue with the company that issued them, the price of a preferred stock is basically determined by the fluctuation of interest rates in general.

Unfortunately, at this time because interest rates are at extremely low levels, preferred stocks are probably the worst of all worlds, worse than common stocks and worse than bonds. The main reason for this is that preferred stocks don't have a yield-to-maturity. What that means is that if interest rates go up and stay up for years, you will never get your original investment back.

Here is an example. If a  preferred stock is trading at $100, and it pays $2 per share per year, the preferred stock would yield 2%. But if rates rise to 4%, the value of the stock will drop by 50% to $50 a share, in order to provide a compatible yield ($2/$50=4%).

At least with bonds, you have a fixed maturity amount so that eventually you would get back that amount at some point in the future. And with the common stock, even though you may not make as much yield, you at least have the potential for capital appreciation of the stock.

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