Published March 30th, 2016
By Eli Inkrot
Lately I’ve been demonstrating different ways to supplement your dividend income.
Neither of these methods are for everyone. Making these sorts of agreements brings an added layer of complexity that may not be worth it for your typical buy-and-hold, “set it and forget it” type of investor.
Yet for those looking to increase their cash flow, these two methods are certainly worthy of consideration.
Today I’d like to talk about a third avenue for finding an above average cash flow stream: preferred shares.
Once again, this isn’t necessarily a recommendation, but more a means by which to gain awareness of an additional investment possibility. In detailing this possibility, I’d like to keep it straightforward; you can always get more complicated, but it can be hard to get back to the basics.
What Is A Preferred Share?
A preferred share (or stock) is technically an equity stake in a business, but it shares characteristics of what you would find with both equity and bonds.
The equity part is that it has an underlying claim on the business and you collect dividends. The bond-like portion is that the dividends that you receive are fixed payments.
What’s So Preferential About Them?
Good question. Here’s a look at the basic corporate capital structure:
Source: Market Realist
In the event of bankruptcy or liquidation, preferred equity ranks below debt but above the common equity shares of a company.
The risk that the above chart is talking about relates to the likelihood of being paid back in the event of an adverse circumstance. With an ongoing, profitable business such as Coca-Cola (KO) or U.S. Bancorp (USB) all of these components are satisfied completely.
The potential returns associated with each segment is generally opposite of what you see above.That is, common equity generally has a higher expected return as compared to debt in the long run.
This doesn’t always have to hold, but it’s generally the case.
Note: Many preferred shares are found in the financial (banks and REITs) or “fixed asset” business like utilities, so your typical dividend growth company may not issue preferred shares are all.
You likely don’t own preferred shares for their slight protection in the event of bankruptcy. While your claim might be greater than the common shares, it could still be quite low.
The true benefit of being “preferential,” in my view, is that this means that the dividend payments are preferential as well.
In order for a company to pay its common dividends it must first satisfy its preferred dividends (if applicable) in full. This has an important ramification in poor but not devastating times.
For instance, during the Great Recession Wells Fargo (WFC) was forced to cut its common dividend from $0.34 per quarter to just $0.05. For the common equity holder this was a large blow to your annual income, and an event that you would have not recovered from, income-wise, for many years.
Things turned out differently for the investor who owned preferred shares in Wells Fargo. Because the company was still paying a common dividend – albeit a significantly reduced one – that meant that Wells Fargo had to first satisfy its preferred dividends in full. So the preferred share owner who was collecting a say 6% annual preferred dividend, kept on receiving their full payments. The preferential nature provided a benefit in this instance.
Basic Features of Preferred Shares
For this section I’d like to talk about some basic features that you might run across as you learn more about preferred shares.
Basic Feature #1: Preferential Dividend
This aspect was just talked about, but it’s worth repeating as this could be the second largest draw of owning preferred shares.
If a common dividend is being paid – regardless if its 50% higher or lower than it was (even if only a penny) – the preferred dividends are being paid in full.
Basic Feature #2: Fixed Payments (More Common)
Often preferred shares come with a fixed rate that will be paid in perpetuity. So as an example, a preferred share might have a 6% yield that will be paid every year.
The advantage, and sometimes largest draw, is the above average dividend yield. The disadvantage is that this payment will not be increased. This is quite unlike what many dividend growth investors have come to expect for their payouts over the years.
Basic Feature #3: Floating Payments (Less Common)
Although a fixed payment is common, you can also have floating rate preferreds.
These securities either start with a floating rate, or have a fixed rate for a time before switching over to a floating rate. The rate is often based on a well-known benchmark such as LIBOR.
Basic Feature #4: Lack of Voting Rights
Generally preferred shares do not have voting rights, like common equity does. This likely doesn’t make a difference for the small investor, but it is a reason why management may prefer to issue these shares instead of common ones (among other reasons).
Basic Feature #5: Cumulative vs. Non-Cumulative
Preferred shares can either be “cumulative” or “non-cumulative.”
If a preferred share is “cumulative,” this means that if the company were to miss or not pay any preferred dividends then they would have to make up those missed payments before reinstating the common dividend. A lot of investors look for this feature, but really you don’t want it to get to that situation. You’d much prefer the company to continue paying dividends on the common shares and not to have to worry about the company paying you back later.
Basic Feature #6: Perpetual
Unlike most bonds, preferred stock can be outstanding forever, or as long as the company is around.
Basic Feature #7: Callable
While the preferred shares may not have an expiration date, they could be “callable.”
This means that the company has the option to redeem the shares at a certain price after a date in the future.
So for instance, a company might issue perpetual preferred shares in 2016 with a call date in 2021. This means that if you bought these shares you’d receive your dividend payments (presuming they are being paid) for the first five years at least. Thereafter it’s at the company’s discretion whether or not it wants to keep the preferred shares outstanding or to buy them back.
A company might reissue new preferred shares and redeem the outstanding ones if rates decrease in the future. As an example, if a company has preferred shares paying 8% outstanding and can now sell 6% preferred shares, it could issue new shares at 6% and buy back your 8% shares. There are some special circumstances, but generally this can only be done if it’s after the call date.
So in keeping with the example, you might be able to hold the shares for 5 years or 100 years, depending on the prevailing rates and what the company wants to do.
Basic Feature #8: Liquidation Preference
You’re probably asking, “what is this ‘certain price?’”
The price at which a company can buy back the preferred shares, after the call date, is called the liquidation preference. Often this is the price at which shares were originally sold. So as an example if the preferred shares are sold at $25, this might also be the liquidation preference. You might buy at $25, collect 5 years’ worth of dividend payments, and then the company could repurchase your shares for $25.
Note that preferred shares trade on the secondary market just like common shares. So the market price of a preferred share can be higher or lower than the liquidation preference, based on the likelihood of the share being bought back and the prevailing rates at the time. This means that your return can be higher or lower than just the dividend payments, based on your original purchase price.
Basic Feature #9: Convertible
Some preferred shares have other features like being convertible.
This means that preferred shares are convertible into common shares at either a fixed rate or depending on some other factor, like the common share price in the future.
The convertible portion may be optional (i.e. at the owner’s discretion) or mandatory – set for a certain date.
There are a lot more features out there – participating, supervoting, etc. – but for our purposes the above notes should serve as a reasonable baseline.
From here I’d like to talk about my personal experience and provide a “real life” example of something that is available today.
A Personal Story
I’ve shared this story previously, but I think it serves as a nice baseline of how I think about the securities.
In general I prefer common shares (the returns are apt to be higher), so I need preferred shares to look comparatively attractive.
The year was 2013 and I remember it like it was… well about three years ago. Here’s a bit of my experience related to owning preferred shares:
At the end of 2013 I began acquiring preferred shares in U.S. Bancorp (USB), JPMorgan (JPM) and Wells Fargo (WFC). At the time each security had similar characteristics: $25 starting value, not callable for a few years, perpetual, non-cumulative, qualified dividends, etc. During this time, shares could be purchased for around $20 per share, resulting in dividend yields in the 6.5% range.
That seemed like a reasonable enough value proposition to me. I would collect a 6.5% qualified dividend yield and if the companies wanted to call the securities they would have to pay me a 25% premium to do so.
It didn’t quite work out that way, but I was happy with the result. Shortly after my purchases the share prices increased steadily. Approaching and even eclipsing the liquidation preference of $25 per share. Ordinarily I don’t like to sell (as Buffett would have it: “my favorite holding period is forever”) but in this instance the value proposition had faded away. The 6.5% yield turned into 5.2% and the “buyout premium” had also evaporated.
So I sold my stakes, with annual total returns in the 20%+ range. Moving forward I’d be surprised if these same securities provided such returns in the coming years. Unlike common shares, preferred stock tends to be anchored somewhat by the starting price, so the key can often be buying shares below the liquidation price.
Now I don’t bring up this example to boast. Given the option I would have liked for the shares to stay around $20 or go lower such that I could accumulate more. I provided this actual demonstration to show that it can be useful to monitor preferred shares in addition to common ones. They offer a separate return proposition that can occasionally oust that of your typical stock holding.
A Real Life Example
Of course knowing that some preferred shares traded around $20 in the past is about as useful as me telling you that shares of Walgreens (WBA) started 2013 trading around $37 (as compared to a more recent quote of $83).
It’s nice to have a solid history and process in mind, but really you want to think about what is currently happening.
So let’s work with a “real life” example – something that you could look at today, if you so choose. And by the way, this is in no way a recommendation, just the process of how you might go about searching.
With common shares there’s a bevy of investing websites that will give you information on the security. With preferred shares the amount of information can be lacking.
Incidentally, this is also a clue as to a potential downside – the liquidity of preferred shares is apt to be much lower than common shares, so this can be an important consideration. One place that you can go is this website: dividendyieldhunter.com.
The very first option next to the site’s title will be “Preferreds,” which gives you a drop down menu of a variety of preferred share alternatives. For this demonstration I selected the eighth option – “Preferreds – Qualified Dividends.”
This page will give you a table of preferred issues whose dividends are eligible for qualified status. Note that the holding period for qualified preferred dividends is a bit longer than for common dividends, but the same lower tax rates can apply.
Here’s what that table will look like:
You start with the security description, followed by the ticker, issue price, current price and so on.
For those first learning about preferred shares, the most relevant aspects to start are likely going to be:
- The current price in relation to the call price
- Whether or not the issue is cumulative
- The current yield
- Earliest call date
To continue with the example, I’ll pick out a preferred issue, say “JPM-A.” Again, this is not a recommendation but merely a description of how you might learn more about a particular security.
If you click on this security on the Dividend Yield Hunter website it’s going to give you a little bit of information, but not much more than what is already listed in the chart.
I find that this website is useful to look at a wide range of securities simultaneously, but not necessarily to “drill down” into the details. For that purpose, I like to use Quantum Online.
You can get the same types of tables on this website, but it does require you to register. If you want to look up information without registering, you can do so, but you have to know roughly what you’re looking for.
On the right-hand side of the website there is a “quick search” box.
If you put in “JPM” it will take you to its JPMorgan Chase & Co. page with general information. Underneath the company’s profile, there’s a link called “Find All Related Securities for JPM,” which will bring up – you guessed it – all the securities related to JPMorgan.
From here you can click on “JPM-A” and it will provide you with a good amount of detail on that particular security. Along with a lengthy paragraph talking about the security, it will also show you summarizing information as you see below:
This is a great source of information and can help give a you a feel for the underlying security. Although perhaps dull to read, I find that the link to the prospectus is also helpful.
We could have just input “JPM-A” from the beginning when we first got to the Quantum Online website, but this is the process of finding a security if you don’t know the exact ticker.
Additionally, some websites use a different format for preferred shares. For instance, on dividend.com it’s simply “JPM-A.” On Yahoo Finance it’s “JPM-PA.” And for your brokerage account it could be “JPMpA.” It’d be nice if it were standardized like common tickers, but here we are anyway. The point is that you shouldn’t get discouraged if you don’t immediately find the information that you’re looking for.
Other websites also have more information besides these two, and you can go directly to the company’s website.
What Does This Mean In Terms Of Potential Returns?
So far we’ve talked about the features of preferred shares and how you might learn more. Now let’s think about the potential return that these sorts of securities can provide. We’ll stick with “JPM-A” to continue with the example.
The “coupon rate” (really a dividend rate) for the security when it was issued was 5.45% based on a price of $25. This $25 mark also happens to be the liquidation preference, so that will be important to keep in mind. Investors will receive an annual dividend of $1.3625 for each depository share that they own. This will be paid in four quarterly installments on March, June, September and December 1st.
The shares do not have a maturity date, so they could be outstanding “forever.” However, JPMorgan does have the option to buy the shares back anytime starting on March 1st of 2018 or thereafter. So let’s think about owning shares through this date.
You would receive 3 more dividend payments for 2016, totaling $1.03. For 2017 you’d expect to receive four full payments and one more for 2018. Over the next two years you would anticipate collecting eight quarterly $0.340625 payments for a total of $2.73.
Based on a share price around $25.45 as I write this, you would anticipate collecting approximately 10.7% of your initial capital back in the next two years. If the shares are not called you would go on collecting your $0.34 quarterly dividend until you decide to sell or if the shares are eventually called sometime in the future.
If the shares are called you would still receive ~$2.73 in dividend payments to go along with $25 per share. Your total value would be $27.73, or a total gain of roughly 9%. Note that this is lower than the dividend component by itself because the company is able to buy back the shares below your cost basis. Your annualized gain for this period would be about 4.4%.
Personally, I don’t find this particularly attractive (especially in comparison to your alternatives) but that’s not exactly the point. The point is to be aware of these types of securities should something interesting occur. As a “for instance” if shares were trading around $20 instead of closer to $25.50, your starting yield would go up to 6.8% and your annualized “return to call” would be near 18%. Granted there is no force that requires a company to call your shares, but it should be clear that the price of the security dictates whether or not it may be attractive.
A final thing to consider is that the common shareholders are effectively issuing the preferred shares. (Not literally, but the company is doing so on behalf of its owners.) As such, it follows that the common shareholder ought to expect to be able to generate returns that outpace what they have to pay in preferred dividends.
This isn’t always the case, but generally preferred shares are issued with the intent to use those funds for an endeavor that provides higher returns. If you can generate a 10% return on the funds you receive, it can make sense to issue a 5% or 6% preferred. Thus the first comparison for owning preferred shares ought to be the common shares of a company.
That’s the nuts and bolts for getting familiar with preferred shares.
The advantage of owning preferred stock is that you begin with a higher starting income, the dividend is preferential (even if the common payout is reduced) and these payouts can still count as qualified income.
The main disadvantage relates to the potential returns and structure of the securities. Over the long-term your total return (and perhaps even total income, although that part is less certain) is apt to be lower. The capital appreciation of preferred shares can be limited or even non-existent. Moreover, the liquidity for being able to buy or sell shares may not exist in a way that you have been accustomed to with common equity.
It all comes down to your personal investment preferences. If you’re happy to collect a 5% yield with limited upside, but a bit of dividend protection there are a lot of securities like that out there today. Alternatively, if you’re looking for a bit higher yield and / or return possibility the majority of preferred issues may not appear attractive at present. Yet that doesn’t mean you ought to write them off completely.
By being aware of the security class you can revisit this possibility in the future to see if anything interesting is being offered.