Let’s be honest, everyone loves preferential treatment, whether it’s priority boarding for a flight, VIP treatment at your favourite band’s concert, or a complimentary upgrade when checking into a hotel room.
Investors are no different, which is why preferred stocks are popular additions in many portfolios.
Understanding preferred stocks
Preferred stocks – also known as preference shares – are typically a hybrid investment that offers features of both stocks and bonds. These shares pay fixed dividends, normally linked to the prime interest rate, and give holders a higher claim on assets and earnings than those who hold common stock.
The issuing company confirms exactly how much the fixed cash payment will be (usually shown as a percentage of the par value) upfront, with preference share dividends typically linked to benchmark interest rates and not company performance.
As such, preferred stocks usually offer higher dividend yields than common stocks or investment-grade bonds issued by the same company, making them attractive for investors focused on generating income, such as retirees.
Importantly, this amount is usually fixed and guaranteed. It doesn’t typically change the way regular stock dividends can go up and down, so investors know what they’re getting from the start and enjoy less volatility. However, these stocks typically do not carry voting rights.
There are several types of preferred shares, each with distinct differences:
- Callable: The company retains the right to buy back shares if the stock hits a pre-set maximum price.
- Convertible: The investor holds the right to exchange preferred shares for common stock shares.
- Cumulative: The issuing company commits to paying any overdue dividends to preferred shareholders before paying any dividends to owners of common shares.
- Non-cumulative: Any missed dividend payment by the company will not be made up in future, and the investor has no claim on it.
- Participatory shares: Shareholders get bonus dividends if the company meets specific profit goals.
- Perpetual: The issuing company will not expressly purchase back the shares, which means investors have to sell the preference shares to receive a return on investment.
- Redeemable: The issuing company can redeem the preference shares held by the investor at a future date for a fixed amount.
Preferred stock ETFs
A simple and effective way to gain exposure to a range of preferred stocks is through an exchange-traded fund (ETF).
Preferred stock ETFs invest in a basket of preferred stocks, which means investors receive income from multiple stocks while also benefiting from baked-in diversification with their investment spread across several companies, which is a prudent risk mitigation strategy.
Preferred stock ETFs also trade on major stock exchanges, like a common stock, which provides increased intraday liquidity, which is not common for individual preference shares, as investors tend to buy and hold these securities.
Preference stock ETF benefits:
- Access domestic and global preferred stock markets in a single fund.
- Gain instant diversification through a basket of preferred stocks from many different companies and often different industries.
- Easily track the investment results of an index composed of preferred stocks.
- Generates consistent income that can be competitive with high-yield bonds.
- Preferred shareholders receive their fixed dividends before common stockholders are paid.
- A less volatile option than common stock, offering bond-like price stability.
Ultimately, preferred stock ETFs allow retail investors to access a diverse, high-yielding, and relatively stable income stream with the ease of trading and liquidity of an ETF, all while benefiting from the priority status of preferred stock in the company’s financial hierarchy.
