Preferred stocks are among the best investments you can make. However, before you take plunge, you need to know the most basic things about preferred stocks.
Describing a Preferred Stock
A preferred stock is considered a hybrid security, which means that it has the characteristics of both bonds and stocks.
Like bonds, they pay out dividends, which make them appealing for investors who are looking for income. And like stocks, preferred stocks can appreciate in value. If you are looking for an investment that straddles both of these goals – income and growth – you might want to consider investing in preferred stocks.
These are particularly good options when you are just beginning to start investing early or if you are already nearing retirement. Preferred stocks are less volatile that common stocks.
Interest Rate Risks
On the other hand, before you pour your money in preferred stocks – or any kind of fixed-income investments – it is important to learn their relationship with the movements of interest rates.
In a nutshell, when interest rates decline, the price of a preferred stock is likely to rise. Conversely, when interest rates rise, the price of a preferred stock is likely to decline.
Understanding this correlation important, although it doesn’t tell us all the things that we need to know. Bear in mind how much the price is likely change. Check if the change will be large and meaningful or if its small and insignificant.
Duration is the measure of the sensitivity of the price of preferred stock or other fixed-income investments to the changes in interest rates.
Duration is counted in years. Higher duration means greater sensitivity, or decline, you can expect from the price of your preferred stock.
Typically, for every 1 percent rise in inflation, a preferred stock’s price would be expected to slide 1 percent for every year of duration. The opposite would be true for a 1 percent decline in interest rates.
If your preferred stock has a duration of 10 and interest rates decline 1 percent, you can expect the value of your preferred stock to appreciate 10 percent. The opposite would be true if the rates increased 1 percent.
Preferred stocks have fixed dividend, which means you can calculate the value by discounting each of these payments to the present day. This fixed dividend is not guaranteed in common shares.
If you take these payments and calculate the sum of the present values into perpetuity, you will be able to find the value of the stock.
Even though preferred stocks give dividends, which are usually guaranteed, payment can be slashed if there are not enough earnings to accommodate a distribution. You should account for the risks of such lowered payments.
The risk increases as the payout ratio, which is dividend payment compared to earnings, gets higher. Additionally, if the dividend has a chance of growing, the value of the shares will be higher than the result of the constant dividend calculation.
Further, preferred stocks usually lack the voting rights that common shares provide. This might be a valuable feature to individuals who own large amounts of shares, but for the average investor this voting right doesn’t have much value. On the other hand, you still need to account for this in order to evaluate properly the marketability of preferred shares.