Investing in preferred stock can be quite intriguing, but it comes with its fair share of risk factors. Let's say you're eyeing a stock that offers an 8% dividend yield. This might sound attractive compared to the 2% or 3% yields you see in common stocks or bonds. However, keep in mind that preferred stock dividends are not guaranteed. If a company hits hard times, such as during the 2008 financial crisis, they might suspend dividends entirely. General Motors, for instance, had to cut dividends even on their preferred stock during the said crisis, leaving many investors in a lurch.
In the realm of investing, terms like "callable," "convertible," and "cumulative" are critical when assessing preferred stocks. Callable preferred stocks can be bought back by the issuer at a predetermined price after a specific date. Let's say you buy a preferred stock at $100 per share, and the company can call it back in five years at $105. If interest rates decline, they might call it back, and you'd miss out on higher dividends, leading you to reinvest at a lower rate. Convertible preferred stocks offer a way to convert shares into common stock, but the ratio and timing matter. Imagine a scenario where the conversion ratio is 1:1, yet the preferred stock's price plummets while the common stock surges; you'd lose out on potential gains.
Interest rate risk is another biggie. Preferred stocks often have fixed dividend rates. When interest rates rise, the fixed dividend becomes less attractive, driving the price of the preferred stock down. During periods of rising interest rates, you might see your $100 preferred stock drop to $90 or even lower. It's like holding a long-term bond in a rising interest rate environment; the market value decreases as newer issuances offer higher returns. The 1980s saw this phenomenon when the Federal Reserve raised interest rates to combat inflation, drastically affecting long-term fixed-income securities, including preferred stock.
The creditworthiness of the issuing company also can’t be ignored. Preferred stockholders get paid before common stockholders but after bondholders. Say a company like Lehman Brothers files for bankruptcy. Bondholders would get their due first, and if there's anything left, preferred stockholders might see some returns. Often, though, the reality is that there's nothing left for preferred stockholders in such cases. Credit ratings from agencies like Moody's or Standard & Poor's can provide some insight into the risk, but remember, even AAA-rated companies can falter – think Enron.
Marketability or liquidity risk is something one should consider as well. Suppose you want to sell your preferred stock quickly. If the stock isn’t traded widely, you might not find a buyer at your desired price. Liquidity levels of preferred stocks generally fall below those of common stocks, making them harder to sell, especially in a volatile market. During the COVID-19 market crash in March 2020, liquidity dried up across various securities, including preferred stocks, making it tough for investors to offload their holdings without accepting steep discounts.
Tax treatment differences are worth mentioning. The dividends from preferred stocks often qualify for "qualified dividend" tax rates, which are generally lower than ordinary income tax rates. But state and local taxes can also apply. Imagine you’re in a high tax bracket; the tax savings on qualified dividends can be substantial. For example, a dividend yielding 8% may yield an after-tax return of closer to 6% when state and federal taxes are considered. This was particularly relevant after the 2003 Jobs and Growth Tax Relief Reconciliation Act, which significantly reduced the taxes on qualified dividends.
Regulatory risk is another crucial element to consider. Preferred stocks issued by financial institutions face several regulations that might impact their performance. Banking regulations can affect the ability of these institutions to pay dividends if their capital levels fall below regulatory requirements. Post-2008, regulatory changes under Dodd-Frank significantly impacted the financial industry, making it more difficult for banks to pay dividends on their preferred stock without meeting stringent capital requirements.
Inflation risk is an often overlooked yet critical factor. Suppose you have a preferred stock with a fixed 5% dividend rate. Over time, if inflation runs at 3%, your real return is just 2%. During the high inflationary periods of the 1970s, fixed-income securities, including preferred stocks, lost significant value in real terms as the purchasing power of fixed dividends eroded.
Economic downturns amplifying these risks cannot be overstated. In a recession, companies might halt dividends to preserve cash. Take the recent 2020 recession induced by the COVID-19 pandemic. Many companies, especially in hard-hit sectors like airlines and hospitality, either cut or suspended their preferred stock dividends to conserve cash. This devastated preferred stockholders who relied on those dividends for steady income.
Understanding the differences between preferred and common stock can offer more insight into these risk factors. Here is a useful link: Preferred and Common Stock. With this knowledge, navigating the intricate landscape of preferred stock investments can become a lot more comprehensible.
Lastly, investor sentiment also plays a big role. Market moods can swing widely based on news and events, impacting preferred stock prices. For instance, a company’s announcement of a major acquisition or divestiture can trigger volatility. If investors perceive the acquisition as risky, the company’s preferred stock might decline. This was evident when AT&T announced its acquisition of Time Warner; there was considerable fluctuation in AT&T's preferred stock as investors digested the associated risks and costs.