Preferred stocks (PS) generally pay above average (over stocks and bonds) fixed income, usually quarterly. Many are taxed at the 15% dividend rate rather than income rate.

Four types of preferred stock exists: cumulative preferred, noncumulative, participating, and convertible.

Generally utility companies, financial, and REITS issue preferred stock.
Preferred stocks are rated by agencies such as Moody or Standard and Poor based on the creditworthiness of the issuing corporation.

Cumulative Preferred

Cumulative preferred stock has its dividends accumulate in case the company decides to restore them. They must be paid off before common stock dividends.

Noncumulative Preferred

Noncumulative preferred stock does NOT have its dividends accumulate so if the company decides to restore paying they do not have to pay any dividends in arrears.

Convertible

PS can be converted into common stock.

Participating

Participating preferred stock gives the holder the right to receive an additional dividend based on some predetermined condition.

The additional dividend paid to preferred shareholders is commonly structured to be paid only if the amount of dividends that common shareholders receive exceeds a specified per-share amount.

Furthermore, in the event of liquidation, participating preferred shareholders can also have the right to receive the stock’s purchasing price back as well as a pro-rata share of any remaining proceeds that the common shareholders receive.

For example, suppose Company A issues participating preferred shares with a dividend rate of $1 per share. The preferred shares also carry a clause on extra dividends for participating preferred stock, which is triggered whenever the dividend for common shares exceeds that of the preferred shares.

If, during its current quarter, Company A announces that it will release a dividend of $1.05 per share for its common shares, the participating preferred shareholders will receive a total dividend of $1.05 per share ($1.00 + 0.05) as well.

Participating preferred stock is rarely issued, but one way in which it is used is as a poison pill. In this case, current shareholders are issued stock that gives them the right to new common shares at a bargain price in the event of a hostile takeover bid.

Pros

Above average income

Preferred stock generate above average income over stocks and bonds.

Issue principal returned

Most preferred stocks return their original issue price (usually $25) when called. An investor can make capital gains if the preferred was purchased below the call price. Of course, the investor can always sell the stock.

Dividends are paid before common stock holders

Some income is classified as dividends

Many preferred’s dividends qualify as true dividends so they are taxed at the 15% dividend rate rather than income rate.

Dividend paid at a fixed rate

Most preferreds pay dividends at a fixed rate, usually a percentage of par value, but may be suspended if the company cannot pay them. There are floating dividends, too.

Corporations get a tax break

Corporations only have to pay tax on 30% of the dividend received which makes it a great investment for corporations.

Cons

Dividends not adjusted to inflation

Since dividends are fixed they are not adjusted for inflation.

No voting rights

Though the owner of preferred stock has a stake in the company, he has no voting rights.

Dividends are paid out of after tax funds

A company pays preferred stock dividends out of money that has already been taxed.

Preferred stock can be called

Nearly every preferred stock as a call provision in it, generally 5 years, so if interest rates go down they can call the stock and reissue at lower rates. The call price is usually the par value (i.e. the original purchase price).

No maturity date

Most PSs are issued in perpetuity. If the interest rate increases, the price of the PS decreases; just like a bond. Since there is no maturity date on PS the price may stay low for years whereas as a bond’s maturity date nears the price of the bond increases toward its par value.

Details

Make sure you understand all the details of the preferred stock, such as its class, call provisions, dividend classification, before investing.

Preferred Stock Mutual Funds

There are a few closed end funds that invest primarily in preferred stocks. They usually are leveraged which boost their yield and volatility. Closed end funds have a fixed number of shares and are sold on a stock exchange.

Risks

* Deferral Risk-Traditional preferreds contain provisions that allow an issuer, under certain conditions, to skip (in the case of “noncumulative” preferreds) or defer (in the case of “cumulative” preferreds) dividend payments. Fully taxable or hybrid preferred securities typically contain provisions that allow an issuer, at its discretion, to defer distributions for up to 20 consecutive quarters. If the Fund owns a preferred security that is deferring its distributions, the Fund may be required to report income for tax purposes while it is not receiving any income.
* Redemption Risk-Preferred securities typically contain provisions that allow for redemption in the event of tax or security law changes in addition to call features at the option of the issuer. In the event of redemption, the Fund may not be able to reinvest the proceeds at comparable rates of return.
* Limited Voting Rights-Preferred securities typically do not provide any voting rights, except in cases when dividends are in arrears beyond a certain time period, which varies by issue.
* Subordination-Preferred securities are subordinated to bonds and other debt instruments in a company’s capital structure in terms of priority to corporate income and liquidation payments, and therefore will be subject to greater credit risk than those debt instruments.
Liquidity-Preferred securities may be substantially less liquid than many other securities, such as U.S. government securities, corporate debt or common stock.

My investment strategy

Buy a cumulative (or noncumulative of a good company BBB or higher) fixed rate (like 6%) below par value and a call date of several years out. The fixed rate should be a percentage point or two over a 10 year treasury note. This is especially attractive if the interest rate is expected to drop. This will bring in income and if called, a nice capital gains. The downside would be if interest rates spiked up high.

Favorites

Quantum Online - great place for preferreds
Wiki Preferred Stock - more in-depth definitions

Summary

Royalty trusts purchase the rights to royalties from the cash flow and sale of a natural resource company, generally oil or gas. They provide a higher than normal (stocks and bonds) yield. Popular ones are Canadian royalty trusts (canroys) and U.S. royalty trusts (usroys). Each have their advantages.

Pros

Above average income

Royalty trusts generate above average income compared to stocks and bonds.

Depreciation and depletion can be written off

Since the RT is a depreciating asset, a portion of the income is considered a distribution can be written off, i.e. the cost basis is reduced.

Possible tax credit

Some RTs use energy from unconventional resources and may qualify for a fuel tax credit.

Cons

No principal returned at the end of the trust

The original investment is generally never returned at the end of a trust. It is returned as ‘return of capital’ and can be deducted on income tax returns. This is because a RT is a depleting asset that eventually turns into nothing.

Income varies

The income generated varies and is not fixed, like a bond or preferred stock. So a 10% yield may go higher or lower over time. The price of the commodity, generally oil or gas, can vary which impacts the income. Income is usually distributed on a quarterly or monthly basis.

The income is not a dividend

The income generated is not a dividend so it is taxed as such.

Part of the income is considered “return of capital”

Owners are required to file report the pro rata portion of a trust’s total income and expenses on their tax returns. This typically means filing Schedules E and B as well as having additional work with Form 1040.

State income taxes

Owners of trusts are liable for paying income taxes in the states in which the trust generates its royalties. Different states have different thresholds for when taxes have to actually be filed and paid, and the likelihood of owing income tax in multiple states increases with the size of a given ownership position.

U.S. royalty trusts have a finite life

U.S. royalty trusts cannot buy and sell assets (unlike Canadian trusts) thus they have a finite life.

Canadian Royalty Trusts

Canroys are open-ended royalty trusts, meaning they can add assets anytime. Canroy owners pay a 15% foreign tax which is put on the U.S. tax return as a nonrefundable tax credit (i.e reduces your tax payment).

U.S. Royalty Trusts

usroys are closed-end royalty trusts, meaning they have fixed assets. Most usroys are oil and gas related so they are depleting assets and have a finite lifetime.

Details

Look for the expected life left of the trust.

This blog is my holding area for the notes I collect while researching investment ideas.