$Retirement Nerd

How do Preferred Stocks work?

How do Preferred Stocks work?

My first retirement account was a Schwab IRA that my mother helped me open with a small inheritance from my Grandmother. The first investment I made was in an S&P 500 Index fund from Vanguard that I bought over the phone. In the long run, the S&P 500 has averaged about 10% return, so this is probably a good place for most people with a long term horizon. As I learned more about the markets and investing, I shifted to almost 100% allocation to common stocks. Now that we’re approaching retirement, we are moving into other investment instruments to build our income and preserve capital.

Diversify. In stocks and bonds, as in much else, there is safety in numbers.

JOHN TEMPLETON

One equity type that I only started buying bought in the last few years is preferred stock. As explained on Investopedia, preferreds are a hybrid between a stock and a bond. With the low interest rates since the Great Recession, I had avoided bonds, since they may tend to decline as rates inevitably increase. Preferreds seemed like a good alternative to provide higher income while being less volatile than common stocks.

If we look at a chart of a preferred that we own, American Finance Trust Inc Preferred Shares Series A (AFINP), we can see that it is less “volatile”. Well, if we focus on the chart prior to the debacle of 2020 and since January 2021, you can see what I mean. As it turned out, the huge drop in 2020 was followed by a huge recovery, so if you held on or maybe averaged down, you probably ended up ok. Most investments seem to have crazy graphs like this for the past couple of years.

AFINP – Chart from Yahoo Finance

We purchased AFINP in September 2019 @ $25.56, but reinvested dividends and bought more on the way down to bring the average price to $23.20. So, we have a small capital gain of 10% with the current price around $25.56. However, our focus is on the income that the preferred generates, which is based on a fixed income payment of 7.5%. In terms of income, we have received an additional 10.9% in dividends ($807.58 on $7,395.27 of cost basis).

The 7.5% isn’t really “fixed”, but it’s based on the annual dividend of $1.88. Preferred stocks have a “par” value, like bonds. AFINP like many others has a par value of $25. The “7.5%” is based on the calculation at par value: $1.88/$25 = 7.52%. So, the actual income rate is based on the market price, which fluctuates as we can see in the graph. Remember, don’t get hung up on the “yield on cost” (YOC), since it may be misleading as discussed in another Retirement Nerd article.

The par value is what the company would pay when/if the preferred stock is “called”. Preferreds can have a “call date” where the company has the option to redeem the shares at the par value. This contributes to the low volatility or low beta for preferreds, since it sets somewhat of an “anchor point” for the price.

You may be wondering why a preferred would trade higher than the par value, since you could lose money if you pay a higher price than the par value and it ends up getting called. Similarly, you may want to buy any preferred below the par value since you have “guaranteed” profit if they call it. The market will determine the price, so there are many factors to affect the preferreds. For example, the company may not call the stock due to the terms, so the price can get bid up above par since investors want to get the fixed income. The price can dip below par if the company is not in secure financial standing, or just from other market factors. See any number of companies impacted by COVID-19 in 2020.

We need to do our own due diligence since the company can end up going bankrupt and we can lose principal. Regarding bankruptcy, one benefit of preferreds is that they are one step up in the capital stack above common shares. They are “senior” to the common stock, but also “junior” to the debt instruments (bonds). A preferred investor would be paid before a common stockholder, but not before a bondholder.

Another factor for preferreds is that they are often “cumulative”, meaning the company may suspend dividend payments, but they must pay any missed dividends in arrears. No common stock dividends can be paid before the preferreds holders are made whole. An example of cumulative dividends for a preferred that we own is Hersha Hospitality Trust (HT-D). This is a Real Estate Investment Trust (REIT) in the Hotel and Lodging space, that got walloped as part of COVID-19. We had purchased a few lots in 2019 around $24/share, but it dropped pretty far in 2020 into the single digits. Yikes! On 4/13/2020 we doubled down at around $8/share so our average price went down to $16.74/share. To add insult to the cap gain loss at the time, Hersha also suspended their quarterly dividends for April 2020, July 2020, October 2020 and January 2021. This was probably a prudent move considering the unknowns, but still disappointing if you invested for the income.

The recovery has been unprecedented, and in early 2021 Hersha announced that they were paying the missed dividends on the preferreds for 2020 and 2021, and even announced the dividend for April 2021. Now we can see that it’s trading near par, which did not seem likely at all last year. In March 2021, we received a payment of $365 for all previously missed dividend payments. On our Cost Basis of $3,765 this adds about 9.7% to the 44% capital gain. It was nice to see the cumulative dividends actually come to fruition and play out one of the theoretical benefits of owning preferred stock. Hopefully the future will demonstrate the low volatility with juicy income that we are seeking from preferreds, without the guy wrenching drop!

A final consideration, as with any investment, are the tax implications. Some preferreds have “qualified dividents” (QDI), so these may make sense to hold in a taxable account. This is one focus of our retirement saving budget, to build qualified or otherwise tax-advantaged passive income to bridge the gap until we can access our tax-sheltered accounts. Other preferreds can be taxed as ordinary income or through a K1 based on their structure, so we definitely need to weigh this and decide whether to invest and which accounts to use (401k, Roth, taxable, etc.).

Still learning a lot about different types of investments and experiencing the benefits and drawbacks. I subscribe to the High Dividend Opportunities (HDO) service on Seeking Alpha and really appreciate the insight and knowledge for income focused investing. Definitely do your own due diligence and consult with a financial adviser or tax professional as needed.

Subscribe to get email updates when we post new content and please discuss further in the comments below or let me know if you have any questions or other feedback.

~$Retirement Nerd🤓

Disclaimer: I am not a financial planner and content on this site is meant to provide food for thought, not professional advice. I share my experiences to show what worked so far and what didn’t, YMMV. Please consult your financial advisor or tax professional as needed.

By $Retirement Nerd

$Retirement Nerd is in his late 40s and looking to retire in the next few years.

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