Preferred stocks are routinely sold to retirees to provide income in retirement. Most preferred stocks are issued at $25 per share, and normally trade on an exchange. As a result, an investment professional can build a preferred stock position for an investor with relative ease. New issues of preferred stocks routinely come to the market, so investment professionals can sell shares to investors at $25 per share, which usually includes a built in .50 per share commission for the investment professional, or 2% of the offering price. These transactions are processed off the exchange. Most preferred stock pay a quarterly dividend and have an interest rate greater than bonds. Preferred stocks almost sound too good to be true. Unfortunately, that is how many investment professionals sell preferred stocks to their clients.
Those investors whose investment professionals recommended preferred stocks as a safe income producing investment prior to or during the 2008-2009 market crash are all too familiar with how volatile preferred stocks can be. In 2008 and 2009, the volatility of preferred stocks mirrored that of stocks rather than the volatility of investment grade fixed income. Because their investment professional never explained the down side of investing in preferred stocks, most investors had no idea that preferred stocks could decline like stocks
Many preferred stocks are issued with no maturity date (perpetual debt) or maturities as long as 40 to 50 years. Many retirees will not live to see these investments reach maturity. Such long-term maturities subject the investor to the credit risk of the issuer for substantial time periods. Investors that owned preferred stock in Lehman Brothers, Bear Sterns, Fannie Mae, Freddie Mac,Wachovia,WashingtonMutual, and AIG learned this lesson the hard way.
Although preferred stocks trade on an exchange, preferred stocks generally trade in very low volume with large price spreads between the bid and asking prices. Accordingly, in a declining market, investors have difficulty selling their preferred stock shares. This is a significant problem for retirees that need to sell their preferred stocks. This important factor is rarely discussed when investment professionals are unloading their firm’s allotment of new issue preferred on unsuspecting clients.
Interest rates are currently at historic lows, however, that means that rates can only go in one direction, higher. As many retirees remember, in inflationary environments, interest rates move significantly higher. While a 7% rate on a preferred stock with no maturity may seem like a great return now, if the inflationary trend continues, interest rates should move significantly higher. Not only will the preferred stocks with a 7% rate decline, but alternative investment options will likely have higher coupon rates with shorter maturity time frames, making it near impossible for the 7% holder to sell their shares without a significant loss.
Preferred stocks may seem like a solid investment when rates are low and the stock market is advancing, however, the Federal Reserve will not keep rates this low if the market rallies. The Fed is much more likely to keep rates low when markets decline. While this may limit interest rate risk short-term, the preferred stocks will be subject to significant market decline. Considering the limited circumstances where preferred stocks might make sense, the “preferred” label is misleading.