A Fee-only Fiduciary Financial Planner’s Thoughts on Preferred Stocks
By Byron L. Studdard, CFP® | Studdard Financial
Years ago, a man named Bill came up to me after one of my investment seminars. He was holding a corporate bond, and he was proud of it. It paid a 5.5% coupon, and Bill believed that was what he was earning.
He wasn’t. Bill had paid more than face value for the bond. Once you account for that premium, his real annual return was well below 5.5%.
That’s a common mistake, but it isn’t the point of this story. The more useful question came next:
Was there a better way to earn income from the very same company?
It turned out there was. It’s a type of investment many investors, and even some advisors, overlook completely.
The Third Option Between Stocks and Bonds
Most people are taught that investing comes down to two choices. You buy stocks for growth or bonds for income.
Preferred stock sits between the two. Legally, it’s ownership in the company, like common stock. In practice, people buy it almost entirely for its fixed, predictable dividend, the way they’d buy a bond for its interest.
It’s called “preferred” because of where it stands in line:
- Before common shareholders on dividends. A company can’t pay common stock dividends until its preferred holders have been paid.
- Behind bondholders in bankruptcy. If the company liquidates, bondholders and lenders are paid first. Preferred holders come next, up to the par value of their shares. Common shareholders get whatever is left.
That middle position is exactly why a preferred usually pays more than the same company’s bonds. You’re being paid for standing one step further back in line.
What We Found for Bill
Using our research software, I found that the company behind Bill’s bond had also issued preferred stock. It paid a 7.25% dividend on a $25 par value. It was trading on the exchange for about $22 a share.
This is the part most investors miss: the dividend is calculated on the $25 par value, not on the price you pay.
| Amount | |
|---|---|
| Annual dividend (7.25% × $25 par) | $1.81 per share |
| Price paid | $22.00 |
| Current yield ($1.81 ÷ $22) | ≈ 8.24% |
| Gain if called at $25 | $3.00 per share (≈ 13.6%) |
Bill could have collected a higher income stream than his bond paid – if he was willing to accept more risk. If the company later redeemed the shares at $25, he also stood to gain about $3 a share on top of his dividends.
Why Buying Later Can Beat Buying New
Preferred stock tends to reach investors in one of two ways.
The first is the phone call about a brand-new issue, usually with a warning that “shares are limited.” New issues aren’t bad, but their price often includes underwriting costs and selling commissions.
The second is patience. Once a preferred starts trading on an exchange, the market sets its price, just as it does for common stock. That price often drifts below the original $25. That’s where opportunities like Bill’s show up.
As a fee-only advisor, I don’t earn a commission on either path. That leaves me free to wait for the better price.
The Number That Matters More Than the Yield: Yield-to-Call
Most preferreds are callable. After a set date, often five years after issue, the company can buy back your shares at par.
That cuts both ways:
- Bought below par ($22): A call works in your favor, because you receive $25 for shares you bought at $22.
- Bought above par ($27): A call works against you. You lose $2 a share when the company redeems at $25, and that can erase a year or more of dividends.
Before you buy, compare the current yield with the yield-to-call, which is your return if the shares are redeemed on the earliest date. If you’re paying above par, the yield-to-call is often the more honest number.
Taxes: A Detail Worth Checking
Many preferred dividends from U.S. corporations count as qualified dividends. Qualified dividends are taxed at lower long-term capital gains rates, which can make a preferred more attractive than a bond whose interest is taxed as ordinary income.
Not every preferred qualifies. Trust preferreds, REIT preferreds, and some bank-issued securities are often taxed as ordinary income. Confirm the tax treatment with your CPA before comparing after-tax yields. It also affects which account the preferred belongs in.
The Risks You’re Being Paid to Take
A higher yield is never free. Here’s what comes with it:
- Interest-rate risk. The dividend is fixed, so when interest rates rise, preferred prices fall to keep their yields competitive.
- Call risk. When rates fall, companies tend to redeem their preferreds. You get your money back just when reinvesting it pays less.
- Inflation risk. A fixed dollar payment buys less every year that prices rise.
- Liquidity risk. Preferreds trade less than common stocks. That can mean wider bid-ask spreads and sharper price swings when markets are under stress. Bill’s issue traded about 70,000 shares a day, which is reasonable, but many trade far less.
- Skipped dividends. With cumulative preferreds, missed dividends pile up and must be paid before common shareholders get anything. With non-cumulative preferreds, which are common among banks, a skipped dividend is gone for good.
Five Questions to Ask Before Buying a Preferred
- Is it cumulative or non-cumulative?
- When is the first call date, and what’s my yield-to-call at today’s price?
- Am I paying above or below par?
- How many shares trade each day?
- Are the dividends qualified, and which account should hold it?
If you’d rather not track call dates and credit quality issue by issue, a preferred stock ETF spreads your money across hundreds of issues and typically pays monthly. The trade-off is that you give up the ability to buy individual issues at a discount the way Bill could.
The Real Lesson
I’m not telling you to sell your bonds and buy preferreds. Bill’s story is about something bigger.
Too many investors judge an investment by what it has already earned. The better question is what it’s likely to earn from here. That’s investing through the windshield instead of the rearview mirror.
Ask yourself: “If I were investing this money today, would I still choose this investment?” If the answer is no, it’s worth finding out why you still own it.
Frequently Asked Questions
Is preferred stock safer than common stock?
In one sense, yes. Preferred holders are paid before common shareholders on both dividends and in bankruptcy. But preferreds rank below bonds, and their prices are very sensitive to interest rates.
Is preferred stock better than bonds?
Not automatically. Preferreds often pay more than the same company’s bonds, but they rank lower in bankruptcy, are usually callable, and often have no maturity date. They work best as part of an income strategy, not as a direct replacement for bonds.
How do I calculate a preferred stock’s yield?
Multiply the dividend rate by the par value to get the annual dividend, then divide by the price you pay. A 7.25% preferred with a $25 par pays $1.81 a year. Bought at $22, that’s about an 8.24% yield.
What happens when a preferred stock is called?
The company buys back your shares at par, usually $25, and the dividends stop. That’s good news if you bought below par and a loss if you paid above it.
Are preferred stock dividends taxed as qualified dividends?
Many are, but trust preferreds, REIT preferreds, and some bank issues are taxed as ordinary income. Check each issue with your tax professional.
Wondering Whether Your Income Investments Still Make Sense?
If you own bonds, CDs, or annuities and you aren’t sure they’re still the best use of that money, I’m happy to take a look. I’m a fee-only fiduciary, so I’m paid by clients, not commissions, and I’m legally required to put your interests first.
Call 901-355-4713, or email Byron@StuddardFinancial.com. Offices are in Sarasota, FL and Germantown, TN, and I work with clients nationwide.
About Byron L. Studdard, CFP®
Byron L. Studdard is a CERTIFIED FINANCIAL PLANNER® professional and the founder of [Studdard Financial](https://studdardfinancial.com/) – a fee-only fiduciary registered investment adviser serving clients from coast to coast from offices in Sarasota, FL and Germantown (Memphis), TN. For more than thirty years, he has provided personalized investment advice, retirement planning guidance, social security maximization strategies, and intergenerational wealth-transfer support to clients seeking disciplined, trustworthy financial oversight. His writing has been featured on the websites of ABC News, Good Morning America, and Yahoo. He can be reached at Byron@StuddardFinancial.com.
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