What are preferred shares?

 

Preferred shares are a different class of shares than the “common” class that most investors are familiar with. Preferred shares typically offer no voting rights to shareholders, are callable by the issuing company (that means they can buy them back from you at any time past the “call date” for a predetermined price), and usually offer a higher dividend in exchange for less share price appreciation.

To learn more, start by bringing up your broker’s website. Below we are using Scottrade to look at preferred shares of the financial company JP Morgan (but show many more brokers below).

Scottrade - JPMpI search

 

For this example, lets look at the last one on the list, JP Morgan preferreds – I series.

There are several important things to take note of here. The Initial Call Date of 9/1/13. This means that any day after 9/1/13 JP Morgan can buy back the preferred shares from investors at the Call Price – or $25 for this issue.

The Coupon refers to the yield of the security at the time it was issued (not the yield today – we will show how to find that later).

Pay Frequency is how often the preferred shares pay their dividend. Here Q is for quarterly (paid every 3 months). Investors may also see an A for annually (paid once per year), an S for semi-annually (paid twice per year) or even an M for monthly.

 

The symbol refers to the preferred’s ticker symbol, just like a stock symbol. Many brokers and financial website have different ways to look up preferred securities. As we see above, Scottrade users type JPMpI to find these securities. (JPM for JP Morgan’s ticker symbol, p for Preferred Security and I for series I.)

To find preferred shares on Yahoo Finance you would search in the format of JPM-PI:

JPMpI - Yahoo finance search

Fidelity Customers search in the format of JPM/PI:

JPMpI - Fidelity search

 

And Vanguard customers type in JPM_pi:

 

JPMpI - Vanguard search

 

By clicking on the share’s symbol, investors can bring up more information on the security.

 

JPMpi info

This screen shows investors the current price of the security ($25.81), the current yield (8.35%) and current dividend payment ($.5391 – on March 1st).

Remember, anytime past September 2013, this security can be called away for $25.00. So investors buying this security today are taking a risk paying 81 cents over the call price (because they may be forced to sell it back soon for only $25.00 – an 81 cent per share loss). Investors purchasing today are counting on receiving at least two dividend payments, or betting JP Morgan will not call away the securities right away.

Preferred shares are typically described as a “half bond-like, half stock-like” security for several reasons:

  • Preferred shareholder’s dividends are paid before common shareholders dividends are paid. If the company can not afford to pay dividends on all common shares, preferred shares technically have the priority to be paid first. Preferred shareholders also have a priority to be repaid in the event of a company bankruptcy. In other words, if a company goes under any cash left over from the company is paid back to preferred shareholders before common shareholders.  However it is important to note that bondholders get paid back before either preferred shareholders or common shareholders on interest payments or in the case of company bankruptcy.
  • Preferred shares have a “par” value similar to bonds, and a set coupon rate.
  • The dividends of preferred shares provide a decent yield, and typically the share prices of preferred securities are less volatile. For these reasons many use preferred shares as a source of fixed income like they would bond holdings.

 

However, this is a dangerous description and commonly leads investors into taking on more risk than they are lead to believe. Lets look at some of the common misconceptions of preferred shares that lull investors into a false sense of security:

 

Preferred shareholders have a priority to be repaid in the event of a company bankruptcy.

Although this is true, it is important to note that this still means investors in preferred shares are still likely to take very large losses (and may very easily get nothing repaid at all) if the company goes under. This fact should not give investors any confidence investing in companies in poor financial status. All too often this fact gets investors buying in with a false sense of security, when really they will most likely receive nothing at all if the company goes under. This characteristic of preferred shares is cited way too often, and should not be a consideration for most investors.

Dividends on preferred shares can still be cut as well. Though the dividends for preferred shareholders have a priority to paid before common shareholders, in the case of financial hardship for a company preferred share dividends may be suspended as well.

Perform the same due diligence you would do to any other investment, if the company is not in good financial health do not invest.

 

Preferred shares are similar to bonds in an investor’s portfolio…

This gets investors too comfortable with preferred shares for two reasons:

First, they expect the security to perform like a bond.

Investors include bonds in their portfolio to reduce volatility. Typically when stocks perform poorly, bonds perform better. However preferred shares do not perform like bonds. Their prices typically go down when the common shares of the company are going down as well.

 

Look at the performance of the I-series preferred shares by JP Morgan over the last 5 years (Same issue shown above):

JPMpI chart

During the 2008/2009 crisis, what you thought was a “safe, bond-like” holding was actually down more than 40%. At a time when you wanted your portfolio to have reduced volatility, preferred shares provided as much volatility as common stocks.

Then, as the general stock market continued to rise through 2010 and 2011, the price on preferred shares stayed steady. Preferred shareholders generally give up potential for share price appreciation in exchange for a larger dividend.

 

Second, because preferred securities can be called away, investors may end up; 1) taking a loss on their investment if they purchased the security above the call price, or 2) Have the security called away when they are dependent on the dividend as a source of income.

Investors in traditional bonds will not lose their principal investment as long as they hold the security through maturity and the company does not default on the bond, this return of principal is not guaranteed in preferred securities if purchased above the call price.

Investors in bonds are also typically looking for a long term source of fixed income. Preferred securities may not provide that if they are eligible to be called away.

 

It is a fallacy that preferred shares can or should replace bonds in an investors portfolio. However with that said preferred securities may fit nicely into an investor’s portfolio as long as they are treated as part of their stock asset allocation and as long as they are purchased under the call price.

 

To read more about preferred shares see our “Fund Spotlight Series” article on Preferred Share ETFs, found here.

Interpretation of Financial Statements, Defines this as:

“Stock which has prior claim on dividends (and/or assets in the case of dissolution of the Corporation) up to a certain definitive amount before the common stock is entitled to anything.”

 

 

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