If you are searching for attractive yields in this low-interest-rate world but don't want to assume high levels of risk, preferred securities may be the solution. Like corporate bonds, preferred securities are issued by major banks, utilities, industrial corporations, and various foreign entities to raise capital. Most preferreds make fixed quarterly payments at a rate that is set when the securities are first issued. (Some newer types pay monthly.) Preferred securities have many other attractive features, including "preferred" status on payments; investment-grade ratings; affordability; and liquidity.
Why are preferred securities "preferred" by investors who are looking for relatively high yields, but who want to retain relative peace of mind?
Payments made to owners of preferred securities have preference over, or are senior to, common stocks. In other words, payments must be made to preferred security holders before dividends can be paid to common stock owners.
The payments of most preferred securities are "cumulative." If, for any reason, preferred payments are suspended, all missed payments must be made up before any common dividends are paid.
Common stock dividends must be suspended before any preferred securities payments can be suspended. However, preferred securities are considered subordinate to a company's senior debt, meaning that interest payments must be made to bondholders before preferred shareholders.
Preferred status extends beyond payments. If an unforeseen disaster occurs and a company is forced to liquidate, preferred shareholders' claims on the company's assets come before common stockholders' claims. Again, however, bondholders' claims are senior to those of preferred shareholders.
Most preferred securities are rated by Standard & Poor's and Moody's investors service as investment-grade quality, meaning they exhibit the strongest capacity to make payments as scheduled.
Preferred securities share characteristics of both stocks and bonds:
STOCK CHARACTERISTICS
Affordable for many investors; a good number of preferred securities trade at $25 per share. Generally listed on major stock exchanges such as the NYSE. This makes it easy to follow their price and adds to their liquidity.
Bond Characteristics
Relatively high fixed-rate dividend payments.
Interest-rate-sensitive; thus, Preferred securities perform more like a bond than a stock.
Preferred securities generally have a call feature that allows the issuer to redeem them by paying a stated price after a specified date. Like bonds, preferred securities are sensitive to interest rates.
If interest rates decline, share prices on preferreds will generally rise. As a result, the preferreds' share price could be expected to rise-possibly reaching or exceeding the call price. In that case, the company may redeem the preferred security after the call protection period expires and possibly issue new ones at a lower rate to the issuer.
If interest rates remain the same or rise, the company is not likely to call or retire the preferred security.
If interest rates rise, the preferred share price may drop, as investors move to higher-yielding alternatives.
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