Dear Mr. Berko: My stockbroker wants me to invest $10,000 by buying 400 shares of Energy Transfer Partners’ 7.625 percent low-rated preferred stock, which sells for $25.33 a share. I can afford the risks of low-rated issues, and the income, which is my prime goal, looks very good. But I’ve never owned a preferred stock, so please tell me how preferred stocks differ from common stocks.
— MP, Akron, Ohio
Dear MP: Both common stock and preferred stock represent ownership in a company. But an important difference between the two is that holders of the common can vote their shares, whereas the preferred owners usually have no voting rights. Another difference is that preferred shareholders have a fixed dividend, whereas dividends for common shareholders are at the discretion of the board. They can be raised, reduced or eliminated. Preferred shares also have a prior claim to the company’s assets and earnings. So preferred stock dividends must be paid before common stock dividends. When a company declares bankruptcy or becomes insolvent and must liquidate its assets, it first pays creditors, and then it pays bondholders, and then it pays preferred shareholders. Common shareholders are last in line to collect assets and hardly get a pfennig.
The dividend yield on a preferred stock is calculated as a percentage of the preferred’s market price, just like the dividend yield on a common stock. Preferred shares trade just like common shares. But preferred shares have a call feature allowing the company to redeem the shares. Preferred shares are always redeemed at a predetermined price, which is often a small premium over their original issue price. Preferred stocks also tend to be more stable in price than common stocks because preferreds pay regular and known dividend streams, whereas the dividends of common stocks can fluctuate. Steady dividend payments from a preferred issue can be more attractive to investors seeking income dependability and continuity, whereas the potential for capital gains with a common stock is more attractive to other investors.
Now, I don’t like and have never liked fixed-income investments. When interest rates rise — and they may continue increasing over the coming few years — the market value of a fixed-rate investment will fall. And if inflation pushes consumer prices higher (as it appears to be doing), the market value of a fixed-income investment will decline. Simply put, if $1,000 of dividends will buy 400 gallons of regular gasoline today, that same $1,000 of dividends may buy only 350 gallons of regular fuel two years hence. So buying fixed-income investments in an environment of rising inflation and interest is just plain bloody stupid.
