Yield pickup through preferred shares

on Jul 5, 2012 in Fixed Income, Home | 2,031 comments

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Investors looking for income vehicles have increasingly focused on preferred shares. Since interest rates are at bottom levels, yield oriented investors have turned to such hybrid securities with the properties of both bonds and shares. Additional feature sometimes includes right to convert preferred shares into common shares at a prearranged price.

Like bonds, preferred shares are commitments by a company to pay an attractive interest to shareholders.

But understand the downside, too. Like bonds, preferred shares are interest rates sensitive. These securities will either never mature or not within the next 50 years, which is ideal for investors interested in locking a dividend for a long period. However you can expect the value of the shares to fall quickly if rates are on the rise.

At the same time, your upside potential with preferred shares is capped because of issuer redemption rights. They generally include a call provision, meaning that the company has the option to purchase the shares from shareholders at face value after five years from the issue date if the price gets too juicy.

Preferred shares are also exposed to credit risk meaning that you are never assured of getting your capital back intact. For preferred shares, the only way you can get your principal back is to sell your shares on the open market.

Like shares, preferred shareholders are subordinate bond holders for a company’s assets if it runs into financial distress. This adds a default risk component to preferred shares, even though they have priority dividend distribution over common shares.

The bottom line: preferred share can be an attractive investment for investors looking for additional income. But, they are definitely riskier than traditional bonds, so you will experience larger price fluctuations for the given yield pickup, which may be unacceptable for risk-averse portfolios.