Preferred stock is considered to be a hybrid security with investment features similar to bonds and common stock issued by the same company. A preferred stock has a promise that it will receive annual dividends stated as a percentage of par value before common stock is paid any dividends. The preferred dividend can be “participating” which means the preferred share holder’s dividend can increase above the stated rate, if earnings are sufficient to pay common shares portion of declared dividends. While the preferred stock has a preference over common stock with respect to dividends, it also has preference in a liquidation of company assets over common stock. The overall investment characteristics of preferred stock make it an ideal investment for risk adverse investors with a need for income and growth potential.
Preferred stock is predominately issued by financial institutions. The preferred markets are dominated by bank, insurance company, and other financial companies because preferred stock and hybrid preferred stock count towards the capital requirements. As a result of the capital requirements, roughly 70% of preferred issues belong to bank, insurance, and other financial companies. An additional 10% originates from REIT/Real Estate issuers, and the remaining 20% is divided relatively evenly among utilities, consumer corporations.
Many investors valued the investment characteristics of preferred stock and accumulated preferred shares in their portfolio until securities concentration increased in these sectors. As a practical matter, investor portfolios became concentrated in preferred stock which reduced the overall level of diversification, increasing risk. The exposure to the financial sector increased risk and was evident throughout the 2008-2009 financial crisis, as the value of portfolios concentrated in preferred stock proved both highly volatile and highly correlated with market declines.
While preferred stock investment characteristics are attractive for most investors, adherence to a disciplined asset allocation outlined in a personalized investment policy statement will help avoid market crashes from a sector’s speculative excesses. A financial advisor can help you keep focused on your True North.
