When the coronavirus pandemic triggered a stock market crash in the first quarter of 2020, I added, for the first time, individual preferred stocks to the Dividend Hunter recommendations list.
It has now been more than a year since that first recommendation, and I am convinced more than ever that preferred stock investments, both individual stocks and with a fund, should be a significant portion of your income-focused portfolio.
Before we get into it, let me point something out. You may notice I use the terms “preferred stock,” “preferred shares,” and “preferreds” interchangeably. They all mean the same thing.
A public corporation issues two types of securities, divided into equity or debt. Common and preferred stock shares are equity or ownership in a corporation. Bonds are debt securities issued by a wide range of entities, including corporations.
Here’s the difference between preferred and common stock…
Common stock shareowners have ownership stakes in a company. They get to vote on items like the board of directors, corporate resolutions, and merger agreements. Preferred stock owners do not have voting rights.
Preferred shares get the name because these shares have a preference over common stock shares when the corporation pays dividends. That means if the company wants to pay common stock dividends, it cannot reduce or suspend preferred share dividends.
For example, on March 18, 2020, hotel REIT RLJ Lodging Trust (RLJ) announced it had reduced its common stock dividend from $0.33 per share down to $0.01 per share. That’s right: a penny per share per quarter. But by keeping the common stock dividend at a penny, RLJ’s preferred share dividends must continue at the regular rate.
Preferred Share Features
Preferred stock shares can be issued with a number of features that you should understand. Each issue of preferreds will have its own set out of this group of elements.
Price and Yield: Preferred stock shares are issued at a $25.00 price with a set yield—for example, the NRZ.PFA shares have a 7.5% yield. Multiply the yield times the share price to get the annual dividend rate. In this case, 7.5% times $25 gives an annual dividend of $1.875 per share, or $0.46875 per quarter.
Fixed to Floating: A preferred stock issue may convert to a floating rate at a future date after the issue date. Our example, NRZ.PFA converts to floating rate after August 15, 2024. After that, the variable rate will be the London Inter-Bank Offered Rate (LIBOR), plus 5.640%.
Cumulative: If preferred shares have a cumulative feature, the issuing corporation must make up all missed preferred dividends if both the common stock and preferred stock dividends have been suspended. The company cannot start paying common share dividends until all of the skipped preferred dividends have been paid to the preferred stock investors.
Convertible: Preferred shares with a convertible feature can be exchanged at a fixed ratio for common stock shares. To convert or not is at the discretion of the owner of the preferred shares.
Callable: A callable feature allows the issuing corporation to call in or redeem the preferred shares for the $25.00 par value. Newly issued preferreds have call protection until a set date. (Almost all preferred stock issues will be callable.) The NRZ.PFA shares cannot be called until after August 15, 2024. But note that just because a preferred stock is callable, that doesn’t mean it will automatically happen. There are many preferreds listed to trade that are years beyond their call dates.
In normal times, most preferred stocks will trade around the par value with yields close to the coupon rates. Prices will fluctuate to reflect changes in market interest rates for similar securities. Again, using NRZ.PFA as an example: this preferred was issued in June 2019, and the share price stayed in a tight range of $25 to $27 before the pandemic hit the stock market.
In the current market, we likely will pay close to par or slightly above for many preferred stocks. That is fine as long as the yield is attractive and the preferreds are not callable for several years at a minimum. I will be monitoring to recommended preferred stocks list to make sure they remain attractive income investments.
The Dividend Hunter recommendations list includes the InfraCap U.S. Preferred Stock ETF (PFFA) for diversified exposure to the preferred stock universe. In addition to PFFA, I now have nine individual preferreds on the list. They all reside in the “Fixed Income Investments” category of the portfolio.
The average yield for the category currently is greater than 7%. For the level of safety these preferred stock investments provide, that is an excellent cash return. I highly encourage you to build up your holdings in these investments. I like a weighting of 25% to 35% of your total income-focused holdings. Of course, your weighting will depend on your personal financial situation.
This article originally appeared at Investors Alley.