Unlike regular stocks, preferred shares can be very different from one another in many ways. For this reason anyone that is interested in making an investment in one of these securities has to really know what they are buying before handling out the cash. There are many different terms associated with these securities like, convertible, callable, cumulative, par value and variable rate. In this article I will discussing what these terms mean to you as an investor.
Convertible shares are those that can be converted into common stock at the shareholders discretion. They have a rate that determines how many common shares the owner would receive if they decide to convert them. What makes them a good investment if bought at the right price is that the investor may be able to get a better return if the stock goes up in price and he or she decides to convert his or her convertible preferred shares. In this aspect they work like convertible bonds. If bought at a cheap price this type of preferred stock can lead to enormous returns. Aside from the fact that they are convertible they generate a fixed or variable income.
Cumulative shares are special in a way. When a stock says it’s cumulative it means that if the company doesn’t pay the dividends that they agreed to, the dividends will keep accumulating. If the company does pay a dividend in the future they will pay the shareholder all the money that they didn’t pay before. Some of cumulative stocks don’t pay anything for many years after they are issued and go up in value because investors believe that at some time or another they will get a huge paycheck from all the dividends that had been accumulating over the years. Profiting from cumulative stocks that are not paying dividends yet is pretty straight forward as long as the company remains in good condition just hold the shares and sell for a capital gain or wait until the company sends a dividend. Depending on your income tax bracket, a capital gain may have lower tax implications than receiving a huge dividend. This is the secret of getting the most out of this type of security. If the company is paying dividends already, the cumulative aspect may act as a dividend warrantee.
Variable Rate Stocks
Shares that have a variable rate depend on the LIBOR index to determine how much they will send out to shareholders. Some send out money according to the LIBOR index while others use it and supplement the dividend with a fixed rate in order to guarantee a minimum amount to shareholders. If the LIBOR index rises the dividend rises but if it goes down so does the dividend. For this reason you have to be careful when you invest in this type of security especially if you are a retiree and plan a budget that includes the income received from investments.
Watch Out for Call Dates
Callable shares are those that can be removed from the market usually after a specified date. After this date the company will redeem the share for its par value. Investors that hold callable shares have to be careful as the call date gets near especially if they want to lock in any capital gains since as the call date nears the share’s price tends to go down or up depending on the particular situation until it sits around the stocks par value. You wouldn’t be in a situation where you bought shares above par value only to get them called by the firm a few months later. The losses would be disastrous in such a situation.
Interest Rate Risks and Preferred Shares
Like all investments there are risks. Aside from the risk of a company going belly up like all fixed income assets, preferred stocks are subject to interest rate risks. This means that if the Federal Reserve hikes interest rates the price of the shares will likely go down. If you own shares that pay a 5% yield and all of the sudden the Federal Reserve starts issuing bonds that pay 6% and pay no state taxes guess what will happen to your preferred shares? All investments compete with one another and investors that own preferred stocks need to periodically check what the Federal Reserve is doing. If you bought shares at par value your shares will probably become undervalued which is ok if you are holding them for many years as a source of income but if you were interested in holding them as a short term you may be in trouble. Even worst if the company calls them before you get some payments delivered to make up for the lower price you may end up recovering only a portion of the invested amount if the par value of the shares is a lot lower than what you paid per share. On the contrary, if the interest rates offered by the Federal Reserve go down significantly, your securities might go up a lot in value leading to a nice capital appreciation. It all depends on what the Feds do. In this way these securities behave like bonds. And contrary to what many believe bond prices can fluctuate as wildly as common stocks in the right conditions. So even investing in fixed income assets requires you to use your head wisely in order to get a good return and avoid potential losses.
In conclusion, type of security is a lot less risky than others but it doesn’t mean that they do not carry any risk at all. The financial health of a company is very important even when shareholders of these stocks receive special treatment. A very important thing to keep in mind is that inflation runs around 3%-4% most of the time, so if you invest in this kind of stock try to find yields higher than that. Of course the higher the yield the better the total returns that you will have on your investment. And if you are a retiree shielding yourself from inflation is still important in order avoid losing purchasing power during the golden years.