Should I invest in Preferred Stocks?

James Ryan Jonas

Most newbie investors think that stocks are the best — and sometimes, the only — choice for investment. Generally speaking, stocks are good investment options, but not all investors will find stocks appropriate for their risk profile or investment goals.

We recently discussed investment objectives in the article What’s your Investment Objective: Capital Appreciation, Preservation, Current Income, Total Return?

If you are still unsure where to put your money in, head over to that article first to determine your investment objective. You will learn that a person’s investment objective will depend on risk appetite, need for income, and investment timeframe.

The same article will introduce you to various investment choices that will be appropriate to your income objective. One of the options is Preferred Shares.

What are Preferred Shares?

Preferred shares are investment securities that generally possess the properties of both debt and equity.

With its debt component, preferred shares normally give investors a fixed, regular income called dividends. Preferred stock investors are normally assured they will receive such dividends at certain dates in the future.

The equity component of preferred stocks, meanwhile, is related to the rights accorded to the investor as part-owner of the company. As part-owner, preferred shareholders are sometimes given voting rights (although most preferred stocks offered in the market are non-voting). Some preferred stocks are also traded on an exchange, although in the Philippines, very few preferred shares are liquid or are actively traded.

To review the characteristics and features of Preferred Stocks, read our comprehensive discussion here: Investing in Preferred Shares vs. Bonds vs. Common Stocks.

Dividend Income of Preferred Shares

One attractive feature of preferred shares is Dividend income. Investors are typically guaranteed that they will receive a fixed amount of income paid on a quarterly, semiannual or annual basis. This dividend rate is explicitly announced when the security is offered to the public.

Take the case of San Miguel Corp. (SMC)’s Series 2 Preferred Shares launched in 2012. Its “Series 2-A” preferred shares pay a fixed annual dividend rate of 7.5%. So if you bought P100,000 worth of Series 2-A preferred shares, you will be getting P7,500 dividends guaranteed every year.

Dividends are taxed at a rate of 10% for individual investors, so if you invested P100,000 in SMC’s Series 2-A Preferred Shares, you should be getting net dividends of P6,750 every year. (See Tax Rate on Cash Dividends in the Philippines)

Preferred Stocks vs. Common Stocks

You’ll notice that the dividend rates of preferred shares are usually higher than the interest rates offered by savings and time deposit accounts. This is one reason why preferred shares are indeed good avenues for investment.

Compared to the returns of common stocks or equities, however, the income rate of preferred stocks may be lower but this subdued return is compensated by the lower risk due to the assurance of income. Loss of capital also rarely happens when investing in preferred shares, unless of course, you invested in a company with a dubious track record.

Preferred share investing is not always 100% safe. Some companies may find it difficult to pay regular dividends but the good thing is, most preferred stocks come with a “cumulative” feature . This means if dividends were not paid in a given year, they will accrue and will accumulate until paid in succeeding years. Common stocks, in contrast, do not have this feature. If no dividends were declared in a given year, dividends will not accrue and will no longer be paid in succeeding years.

Impact of Interest Rates

Some preferred stocks are already listed on an exchange and you will notice that most of them may have a different market price compared to their par value or original price. The price change is typically a result of fluctuations in market interest rates, unlike common stocks were price fluctuations are due to expectations of the company’s future income.

Interest rates and prices have an inverse relationship. Thus, when interest rates rise, the market price of a preferred share may fall. This happens so that the preferred stock will continue to offer an acceptable yield to investors. Similarly, the market price of a preferred share will rise when interest rates are declining.

So don’t be surprised if you checked the Philippine Stock Exchange (PSE) and some preferred shares have different prices from their par value.

Should I invest in Preferred Shares?

Now, back to our original question: Should you be investing in Preferred Shares?

If you are looking to expand or diversify your investment portfolio, preferred shares might be a good addition to your options.

Preferred shares are appropriate for investors with a Current Income objective, that is, those looking for income on a regular basis. If you have no immediate need for your investment capital but want to have a recurring income every quarter or every year, preferred shares might be the one for you.

Preferred shares are also typically chosen by investors with a low to medium appetite for risk, or those willing to trade huge returns for stability of capital. If you do not want to lose money and are looking for stable income, preferred shares may be a good choice.

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James Ryan Jonas teaches business management, investments, and entrepreneurship at the University of the Philippines (UP). He is also the Executive Director of UP Provident Fund Inc., managing and investing P3.2 Billion ($56.4 Million) worth of retirement funds on behalf of thousands of UP employees.