Preferred Dividends: A complete guide to preferred stock income

While dividend investors are typically quite familiar with the mechanics of dividend investing, preferred stocks that pay preferred dividends are not discussed as frequently. Investors seeking income and lower risk investments might be interested to learn more about preferred dividends.

But before we get into specifics on preferred dividends, let’s back up and set the context appropriately regarding dividend investing.

Investors turn to dividend stocks for a number of reasons. Some want to focus on growing their portfolio by reinvesting the dividends, while others want a reliable source of income from regular payments.

With numerous advantages for investors, dividend stocks, especially those paying out a higher yield, are often in high demand. The fact that dividends deliver steady returns from established companies makes them favored by investors who are looking for lower risk securities.

In a low interest rate environment like we’re in today, dividend stocks tend to be in even higher demand. Their yields more easily outperform other fixed-income investment choices like bonds or savings accounts than they do when interest rates are higher and assets like bonds start paying more.

When it comes to dividend stocks, there are a few things to understand before investing.

How dividend stocks work

Dividends are payments made to stockholders when the company performs well, or makes a healthy profit. Investors share in the company’s earnings in this way. Usually, dividends are paid quarterly, but they can also be paid annually.

Not all publicly traded companies issue dividends. Some companies use their profits to put back toward the company to foster growth. They may want to make acquisitions or put more toward funding new operations. So, newer growth companies, including many in the technology sector, tend not to issue dividends. Instead, dividends are more common among established companies with slow and steady growth.

Even if the company’s stock price goes down or it does not perform as well as expected, investors can still receive their dividend. This predictability along with the fact that many tend to be more established companies are part of why many consider dividend stocks to be a lower risk investment.

The amount of a dividend is determined by the company. It is usually a set annual amount, divided into quarterly payments. Sometimes the dividend is also expressed via its dividend yield, which is the payout’s percentage of the stock price.

For example, Proctor & Gamble (PG) recently declared a $3.163 annual dividend, or $0.791 per quarter. With its current stock price around $125, the dividend yield is about 2.39%. However, if the price of PG shares falls, then that yield will increase – although the exact amount of the dividend will remain the same. If PG’s price increases, its dividend yield will decline.

For common stock, the yield can change significantly as the share price rises or declines. However, with preferred stock, in which the value remains fairly stable, preferred dividend yields are more stable as well.

Both the amount of the dividend and its yield vary significantly from company to company, so it’s important to shop around.

Typically, the company will choose a set annual dividend and then issue payments quarterly as the board of directors officially declares them. Many companies adjust their payments, striving to increase dividend payments for investors.

In tough financial situations they may have to cancel their dividend plans and suspend payments, but companies try to avoid canceling dividends so that they can earn the trust of investors. For instance, during the economic challenges of 2020, companies ranging from Wells Fargo to Disney either cut or eliminated its dividend (likely both companies will aim to reinstate its dividend or get it back to previous levels as economic and financial conditions permit).

What is a preferred stock?

Many companies offer investors two different classes of stock – common stock and preferred stock.

The type of stock most people are familiar is common stock, which is essentially gives you a share of ownership in a company along with voting rights. The price of common stock can rise or fall in response to economic influences or other factors that can affect the company’s bottom line (as buyers and sellers trade shares via the open market).

Preferred stock, which also provides ownership in the company, is lesser known, but it offers several advantages. For one, preferred stockholders have first priority of being paid if the company is liquidated. If the company goes into bankruptcy, some types of preferred shareholders are prioritized before common stockholders when it comes to claiming any assets the company has left when it liquidates. (Bondholders and lenders would be paid before preferred shareholders.)

In general, preferred shareholders are at least entitled to their expected dividends. Say a company has $200 million in cash to pay out in dividends one quarter, and its preferred shareholders are entitled to $200 million in dividends. In this case, it is possible that common stockholders would not receive a dividend, and preferred stockholders would receive their full dividend.

Recently, due to the negative impacts of the coronavirus, many larger companies put a halt to their dividends as cash flow dried up from slower revenues or diminished profits. The first investors to lose their dividends have been common shareholders.

Finally, in general, preferred stocks are considered lower risk than common stocks. They may not have as much potential to make the same gains in price, but they also have less risk of losing value than common stocks. Common stock can rise and decline significantly in price depending on market demand. However, the price, or par value, of preferred shares changes very little, which is similar to how a bond works.

How preferred dividends work

The dividends paid on a preferred stock are based on the share’s par value, or initial price. As you can tell, these shares have very similar terminology to that of buying bonds.

Usually, companies are obliged to pay dividends to preferred shareholders. So, even if they skip making dividend payments – say if the company is facing financial stress – the company would likely aim to eventually pay those dividends to preferred stockholders in the future. This isn’t the case for common stockholders, who would not likely see their dividends if the corporation chose not to make its regular payments.

Preferred stocks that are “cumulative” guarantee that the investor will be paid the dividends, even if the company suspends its dividend payments. Those preferred stocks that are “non-cumulative” do not enjoy that same guarantee – the company is not legally obligated to pay a lump sum of accumulative dividends on “non-cumulative” shares.

The bottom line is that it is very unlikely a preferred shareholder will not be paid an expected dividend unless the company is under great financial strain.

Pros and cons of preferred dividends

Pros

• Ownership in company
• Reliable payments
• Priority over common shareholders
• Lower risk
• Often better yield than comparable bonds

A preferred stock gives you a partial ownership in a company, much like common stock does. And preferred stocks that pay dividends have one major advantage over common stocks that pay dividends – the dividend payments tend to be larger.

If you own a preferred dividend stock, you are prioritized over common stockholders when it comes to payouts from the company’s profits in case the company cannot pay all its shareholders the expected dividends.

Also, preferred stockholders enjoy more reliability with the dividends. They receive pre-set dividends on a schedule. In contrast, common shareholders with dividend stocks have no guarantees of whether they will be paid dividends and how much. For common shareholders, how the company performs will generally determine whether and how much they will be paid.

Cons

• No corporate voting rights
• Lower capital gains compared to common stock
• No advantages amid inflation

Of course, if you own preferred stock, you also have some downsides to consider. Namely, you won’t have voting rights when it comes to company matters that could affect the value of your stock. Common stockholders can vote on who sits on the board of directors, whereas preferred shareholders cannot. Other issues that may come up for a vote include stock splits, mergers or executive compensation, among other corporate issues.

Another downside to consider is the fact that preferred shares tend not to rise in price as quickly as common shares, so they are not ideal for growth investing. In other words, the prices of a share of preferred stock doesn’t move as much as it does with common stock, which can have higher capital gains. Instead, preferred stock investors get most of their gains from dividends.

Prices of preferred stock do fluctuate some, but those price changes are driven more by the interest rate environment rather than the company performance. If the interest rate environment is low, investors are more likely to pay more for dividend-paying preferred shares. With common stock, share prices can rise and fall more dramatically on company performance news.

One other thing to consider is the fact that some preferred shares can be “called,” meaning the company can buy back the stock. So, some preferred shares may only offer their dividend for a set amount of time. (More on callable shares below.)

Finally, during times of high inflation, the rate of payments from preferred dividend stocks may not be as favorable as you could get with other investment choices. That’s because the dividends are issued at a fixed rate, so they are not affected by the same interest rate changes that can affect other assets.

An example of preferred stock paying dividends

Not all companies offer preferred stock. In fact, most companies do not. The sectors where you’re more likely to find preferred shares are in financial, energy, utilities and real estate. Corporations here tend to issue preferred shares when they need to raise money but don’t want the expense and hassel of issuing new common stock.

One example of a company paying preferred stock is JPMorgan Chase. The bank recently declared dividends on five types of preferred shares with each paying a different dividend yield:

• 6.10% Non-Cumulative Preferred Stock, Series AA — $0.381
• 6.15% Non-Cumulative Preferred Stock, Series BB — $0.384
• 5.75% Non-Cumulative Preferred Stock, Series DD — $0.359
• 6.00% Non-Cumulative Preferred Stock, Series EE — $0.375
• 4.75% Non-Cumulative Preferred Stock, Series GG — $0.297

In comparison, JPMorgan Chase’s common stock holders get a dividend with a yield of about 3.74% with current trading prices close to $100 per share.

How to find a good preferred dividend stock

Finding stocks that pay dividends is easy because many stocks pay dividends. You can simply screen the stock market for ones that offer payouts on many financial websites online. However, finding a good quality dividend stock that meets your own investing needs is another matter. That requires a bit more time and research.

One of the first factors investors consider with preferred dividend stocks is the yield, or the amount of the dividend. However, yield is not the only thing to consider.

Investors also look at the payout ratio of dividend stocks. That tells them what percentage of its earnings a company is paying to investors through dividends. In the Proctor & Gamble (PG) example above, where the annual dividend is $3.163 and the dividend yield is 2.39% as of mid-June 2020, the payout ratio is 63.6%. An investor considering buying PG may want to compare that payout ratio to the payout ratio of other dividend stocks.

As with any stock, it is also important to research the company’s fundamentals, including trends and past performance in its revenue and earnings, among other key metrics.

How to buy preferred dividend stocks through an ETF

You can purchase shares of dividend-paying preferred stocks through a broker. However, if you’re looking for more diversity, you may want to consider exchange-traded funds, or ETFs, instead of buying several stocks individually.

ETFs are like mutual funds in that they hold several securities, which essentially lowers the risk of a portfolio. You can purchase a shares of ETFs, over an exchanges, just as you would a stock.

Among the ETFs that hold preferred dividend stocks:

• iShares Preferred and Income Securities (PFF)
• VanEck Vectors Preferred Securities ex Financials ETF (PFXF)
• InfraCap REIT Preferred ETF (PFFR)

What is callable preferred stock?

As we mentioned above, some companies issue what’s called “callable” preferred stock. Essentially, those companies can buy back the shares after a certain date. In this case, investors don’t hold the stock for as long as they’d like as they do with common stock.

Companies don’t necessarily have to call back their preferred shares, but sometimes they want to if their current dividend rates are lower. That way, they can save money. For example, a company may choose to buy back shares of preferred stock paying investors a yield of 7% if the preferred shares they are currently issuing are paying a yield of 5%. The companies buy back the preferred shares for “par,” or the initial price of the shares, not its market value. In most cases, par is $25.

In general, rates on callable preferred shares tend to be higher than other preferred shares because investors are giving up their right to hold their shares for as long as they like.

Why not just invest in bonds?

At this point, you might be thinking that investing in preferred stock sounds a lot like investing in a corporate bond. In both scenarios, you’re essentially purchasing the security for the regular income payments and not counting on capital appreciation. However, bonds have a bit more seniority than preferred stocks in the event of liquidation, so due to the higher risk, preferred stocks tend to pay a higher yield than the bonds do.

While bond payments are a before-tax payment for companies, preferred dividends are paid out of earnings similar to common stock dividends.

In general, many investors considered investing in preferred stocks as a bit of a hybrid investment between common stock and bonds. The risk lies in between common stock and bonds while you’re able to get a higher dividend yield than both common stock and bonds.

The bottom line

Preferred stocks that pay dividends offer a number of benefits to investors, with larger dividends being among the top advantages. The income these shares provide is often much more attractive than the income from common stock dividends.

Still, preferred stocks may not be for everyone. There are downsides to consider, such as the fact that this type of stock is not ideal for growth strategies. The value of preferred shares are not likely to increase significantly the way common stock can rise in price.

Remember that just because a preferred stock pays a higher dividend doesn’t necessarily mean it’s better than other preferred stocks paying a lower dividend. There are a number of other factors to consider with each investment decision – the amount of the yield is only one of them.

For more help finding the right preferred dividend stocks for your unique investing needs, consider working with a professional financial advisor. They can help you identify your goals and the best assets to help you achieve them, and review the pros and cons of your choices in preferred stocks.