Preferred stock: Here’s everything you need to know and should you buy?

If you’re ever feeling worried about a company going belly up, you might be able to sleep a little easier at night if you hold preferred stock. It is common for investors to see all their investment evaporate when this happens – just ask former Virgin Australia investors. But if you hold preferred stock, you might be able to get something back.

What is preferred stock?

To put it simply, preferred stock is a type of equity (ownership) in a company that has a higher claim on the company’s assets and earnings than common stock (or ordinary shares).

Here’s a breakdown of the perks that come with it:

Firstly, preferred stockholders receive dividends before common stockholders. These dividends are usually fixed, meaning they’re paid at a consistent rate. If the company’s performance isn’t great, the company can defer dividends but it’s typically expected to pay them later.

Secondly, If the company goes bankrupt or liquidates, preferred stockholders get paid before common shareholders (but after debt holders and bondholders).

Thirdly, unlike ordinary shares, which can increase in value as the company grows, the price of preferred stock is typically more stable. The potential for capital appreciation (price increase) is generally lower than common stock because these stocks tend to have fixed dividend rates.

Fourth, some preferred stocks can be called (or bought back) by the company at a certain price after a specific date. This can be advantageous to the company if interest rates drop.

Of course, in case of the latter two, the specific prices or call back terms can very from company to company.

How to buy preferred stock?

Sometimes this can be the same was as ordinary shares – through a broker. But you need to be sure you are buying preferred shares. Generally, these shares will have a longer ticker code, for instance CBA’s preferred shares have 5-letter tickers (CBAPJ and CBAPH for instance) whilst CBA’s ordinary shares have just the 3-letter ticker CBA.

Should You Buy Preferred Stock?

It depends on your financial goals and risk tolerance. In our view, only if you’re that concerned that your company is going bust, you cannot afford to lose all your money. This being said, if you’re concerned in the first place, should you really be buying that company? No.

You should be buying a stock for its growth appreciation potential and if you don’t think it has potential, why invest in it?

Now, it is true that there is lower risk compared to ordinary shares. Since preferred stock has priority over common stock in terms of dividends and liquidation, it can be seen as a lower-risk option.

However, they are still riskier than bonds (because it’s still equity), and you could lose money if the company performs poorly. Honestly, bonds should be your first choice if you want income rather than capital growth.

We also observe that preferred stocks can be sensitive to interest rate changes. When rates rise, the fixed dividends become less attractive relative to bonds and other fixed-income investments, which can make the price of stocks fall.

Final Thoughts

If you’re looking for regular income with lower risk (but with limited growth potential), preferred stocks can be a good addition to your portfolio.

However, if you’re looking for higher returns and can tolerate more volatility, you may want to stick with common stocks or explore other investment opportunities.

And if you’re that worried about your company going bust that you need a greater certainty of getting some return, you shouldn’t invest in such a company at all.

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