From an old CC post:
|Why I Don’t Like Preferred Stock|
|6/9/2006 9:19 AM EDT|
If I take risk, I want a decent probability of getting paid for taking the risk, and paid well. If I don’t want to take risk, I want a high degree of certainty that I’m not going to lose money, and if I do lose money, it won’t be much.
Having been a corporate bond manager in my last job (2001-03), I learned that I had all of the downside of stocks, with little of the upside of stocks. (One exception: buying MBNA floating-rate trust preferreds in late 2002 for $68 — they were at par ($100) in less than a year, matching the performance of MBNA stock, but that is rare, outside of distress situations. Another exception: fixed-income risk arbitrage was, in many cases, wider than that of equity arbitrage … examples from that era: Golden State, Household International and Allfirst, but I digress…
The situation is worse with preferred stocks. At least with corporate bonds you have a priority call on the assets of the firm in insolvency. Preferred stock typically gets 10 cents on the dollar in insolvency vs. 40 cents or so on senior unsecured corporates and 80 cents on bank debt.
Preferred stocks are called preferred because the dividend on the preferred must be paid for the common stock to receive a dividend. But with speculative ventures where the common doesn’t pay a dividend anyway, that is a small safeguard. Another small safeguard is the ability of the preferred holders to elect a few directors if the dividend is not paid. Nice, but it usually doesn’t tip the balance of corporate governance.
The recent troubles with Fannie and Freddie preferreds, where they lost 80%+ of their value, has hurt the preferred stock market. Well, good. Preferred stock is a vehicle that hates volatility. The preferred holder just wants to clip his dividend payments and receive his principal back eventually. He doesn’t benefit if the common rises (I leave aside convertible preferreds), and he is not protected during times of default.
This applies to all hybrid debt, trust preferreds, etc. They may act like fixed income securities in good times, but in situations of economic stress, they behave more like equity than debt.
Be wary of those that promise high income relative to safer strategies. It is rare that they succeed.