Historically, bonds and stocks have made up the two main asset classes of choice for investors. Conservative investors like bonds for their regular coupon payments, but inflation saps the purchasing power of fixed income. If you were to sell the bond before maturity during a period of rising interest rates, you’ll probably have to swallow a capital loss.

Stocks typically offer higher returns than bonds. Moreover, companies usually increase their dividend payouts over time, so the dividend income can grow to offset the insidious effect of inflation. The other side of the coin is that stocks can be more volatile. In the event that the underlying company goes bankrupt and gets liquidated, creditors (bondholders) will be paid before owners (shareholders).

For investors who like the predictable income that bonds offer but also like the higher capital-appreciation potential that stocks offer, there is an asset class that has features of both bonds and stocks: preferred stocks.

A Balance of Income and Growth

A preferred stock is equity like common stock, but it’s a different class of shares. Preferred stocks typically pay a higher dividend common stocks. For example, the Broadcom Inc. 8% Mandatory Convertible Preferred Stock Series A (NSDQ: AVGOP) yields 5.4%. By comparison, the common Broadcom (NSDQ: AVGO) share yields 3%. Note that the preferred share has a par value of $1,000, so the “8%” means that the preferred shares pay $80 per share per year. The dividend yield is lower than 8% because the market price of the preferred share is more than $1,550, well over its par value.

Thus, a preferred stock has significant price appreciation potential as well. It probably won’t rise as much as common stock if the going is good, but it generally has higher capital appreciation potential than bonds.

Moreover, they have higher priority when it comes to dividend. This means that when a company pays out earnings to shareholders, they have to pay preferred shareholders before they can pay common shareholders. In the event of asset liquidation, preferred shareholders will also get paid before common shareholders (but after bondholders) so there’s a better chance of salvaging some value.

On the other hand, preferred stock is sensitive to interest rate movements, just like bonds. But then, so are income-paying stocks.

More Than One Flavor

Preferred stock comes in different forms. Let’s take a look at two of the main types.

The first is a callable or puttable preferred. A callable preferred stock means that the issuer can “call” (or buy back) the preferred stock from the shareholder at predetermined terms. By contrast, a puttable preferred stock allows the shareholder to put (or sell) the share back to the issuer at predetermined terms.

For example, if interest rates fall, and the company expects to be able to borrow money at a lower rate than it pays out in preferred dividend, then it makes sense to buy back the preferred and issue debt at a lower rate. On the other hand, if the share price has fallen well below par, it would make sense for the shareholder to put the shares back to the issuer if he/she can sell at a higher price than the market price. Because the callable preferred benefits the issuer and the puttable preferred benefits the shareholder, all else being equal, the puttable preferred will trade at a premium to the callable preferred.

The second type is a convertible preferred. In fact, the Broadcom preferred stock I mentioned earlier is a convertible type. It will automatically convert to common stock on September 30, 2022 at a ratio of between 3.0303 and 3.5422 shares.

Thus, this particular preferred stock is automatically converted. Others offer the shareholder the option to convert at a predetermined conversion ratio, usually after a certain date.

For the preferred shares with the option to convert, the shareholder isn’t going to exercise the option unless the terms favor him/her, so this feature is shareholder-friendly.

The bottom line is that preferred stock can be regarded as a hybrid between a bond and stock. Investors who want a high income but also better capital appreciation opportunity than bonds can consider them. Before purchasing a preferred stock, however, be sure to read the prospectus carefully to see what the terms are.

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