What is the difference in risk/return of different types of pref stock (convert/third party/trust/trad)?

Why I Don't Like Preferred Stock

By David Merkel
RealMoney.com Contributor

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 (2001-2003), 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, versus 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 thing that kicked me over the edge on this one was a friend who asked me whether he should invest in the preferred of Quanta Capital Holdings (QNTAP - commentary - Cramer's Take). My answer was, "Don't do it," and the recent price action has borne that out. In addition to the other difficulties that preferred stocks have, the Quanta issue is perpetual, meaning the management never has to return the capital. Quanta management can call the preferred at a small premium to par if things work out, capping the upside. The dividend is non-cumulative, so if it doesn't pay the dividend, there is no remedy. And, there is no right to elect directors upon non-payment.

Making this worse is that Quanta can't pay the preferred because of covenants in its bank loan agreement that secure letters of credit that back reinsurance they have issued. A recent credit rating downgrade from AM Best triggered the covenants in order to protect the banks and those reinsured.

The business that Quanta wrote (aside from messing up in property catastrophe) was very long tail in nature. Many firms have "kicked the tires" on Quanta, and no one decided to buy, I suspect because it is impossible to tell what the quality of the underwriting was. The book value is considerably higher than the common stock price, but whether you could get a reinsurer to assume the liabilities for anything near the value of the reserves is dubious.

Thus the problems with the Quanta preferred: The dividend may not be paid for years, and it will not accrue. The holders have no leverage over management. Finally, it is possible in an insolvency that there will be no payment.

The current price fairly discounts the risks involved, in my opinion, given the large information void on Quanta's underwriting, and the poor performance of their underwriting in other areas. It is possible that a Quanta preferred holder could receive par ($25) in four years' time. It is also possible to receive nothing. It's not a game that I want to play.

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Robert Stepleman

Does preferred stock make it preferable?

Many income-oriented investment newsletters and Web sites advocate that conservative investors skew their portfolios toward preferred stock rather than common stock.

Investors should have a thorough understanding of this type of investment before following any such advice.

One reason is that, as we shall see, preferred stocks come in many different "flavors," and each one has its own risk and reward profile.

Additionally, it is not always obvious whether the preferred stock's dividend qualifies for the reduced 15 percent tax rate, as only a fraction of them have this desirable feature.

Preferred stocks are hybrid securities with both stocklike and bondlike characteristics but are usually closer to bonds than stocks in their risk-reward profiles.

In general, preferred stocks look a bit like common stocks because they pay dividends as opposed to interest and provide the holder with company ownership and sometimes limited voting rights.

They look a bit like bonds because unlike common stocks, the dividends of most preferred stocks are fixed. Additionally, in the event of the company's bankruptcy, the preferred stockholders get paid before the common stockholders.

Here's where things get messy.

Some preferred stocks are "convertible." This means that under certain conditions they can, at the stockholder's option, be exchanged for a specified amount of common stock. This is good because the preferred stockholder can benefit from a rise in the common stock's price.

However, some convertible preferred stocks mandate conversion by a given date rather than making it an option. This is bad because the stockholder must convert even if the common stock's price is so low that the conversion would result in a loss.

Many preferred stocks are "callable." This means that the company has the right to force the preferred stockholder to sell the stock back to the company after a specified date at a predetermined price. This is bad because if interest rates fall, the value of the preferred stock will initially rise in a manner similar to a bond; however, as the call date approaches, the value will fall back to the call price.

A limited number of preferred stocks are "participating." This means that under some circumstances, they receive additional dividends beyond the base rate. This is good because it allows the preferred stockholder to participate in the company's success.

A small number of preferred stocks, instead of paying fixed dividends, adjust them periodically based on some index; for example, the annualized quarterly dividend rate may be set at 4 percent more than the 90-day Treasury bill rate. This is good because it provides protection against rising interest rates.

Most preferred stocks are "cumulative." This is good because if the company suspends paying dividends, it must pay all past-due dividends on the preferred stock before it can resume paying any dividends on the common stock.

Preferred stock has both advantages and disadvantages over the common stock or bonds of the company.

The key advantage is high current income. Normally, the preferred stock will pay a higher dividend than the common stock, and its dividend will also be higher than the interest paid on the company's bonds.

Another advantage is relative price stability. In general, the preferred stock's price will be more volatile than the company's bonds but less volatile than the company's common stock.

The key disadvantage of most preferred stocks is the lack of inflation protection in their dividend. As we already mentioned, unlike common stocks, their dividend is usually fixed and thus its purchasing power will decline with time.

Another disadvantage is the lack of capital gains potential of most preferred stocks. The combination of the "call" date and the fixed dividend provides little opportunity for long-term price appreciation.

Another key disadvantage is that unlike bonds, some preferred stocks are "perpetual"; that is, they have no maturity date when an investor knows that her capital will be returned.

This is bad because, if interest rates increase, the dividend will be worth less, the stock price will fall and the investor may never recoup her capital.

Like bonds, preferred stocks are rated by agencies like Standard & Poor's.

The higher the rating, the less likely the preferred stock is to have difficulty paying the indicated dividend.