Preferred Shares Vs. Bonds: Risks and Rewards

Conservative savers fixate on preferred shares and bonds for investment income and safety of principal. Alternatively, aggressive investors shade towards shares of common stock for capital gain potential, in exchange for assuming extreme day-to-day volatility. As always, it is critical that Onyx articulates basic corporate structure, before presenting recommendations in line with your financial objectives.

Corporate Finance 101

Corporations raise cash by issuing debt to creditors and selling shares of stock to equity owners, as shown by the balance sheet equations, which shows assets equaling liabilities plus shareholder equity.

Bonds are credit securities. Bondholders collect interest payments until the loan is repaid at maturity. Preferred shares are a class of equity that receives dividend payments out of after-tax corporate profits, which may range from zero to infinity.

Preferred shares will typically pay a fixed dividend. A preferred stock that offers a fixed dividend throughout eternity is also known as a perpetuity.

Corporations are legally obligated to make good upon principal and interest payments. Alternatively, financial managers authorize and pay dividends at their own discretion. In the event of bankruptcy, creditors must be made whole first, before shareholders receive any type of compensation.

Preferred shares do carry senior asset claims above common stock. Missed preferred dividends will accumulate and must be paid out prior to common dividends. Preferred shareholders are owners but have no voting rights.

The Interest Rate Environment

As fixed income securities, preferred shares and bonds are highly correlated to the interest rate environment. Here, current and dividend yield are similar statistics that project annual investment income expectations – off an initial investment.

Prevailing interest rates, of course, are never static. As rates move higher, newer fixed income securities offer higher investment income relative to bonds and preferred shares already in circulation. Old bonds and preferred shares must then sell at a discount, in order to attract any investor interest.

Alternatively, lower interest rates are a tailwind for stock and bond performance. Investors then put a premium on older, existing securities to lock in exceptional rates. Wall Street and the bond market fully expect for The Fed to slash rates through the end of 2024, in order to stimulate the economy amid recession.

For bonds, yield-to-maturity (YTM) integrates capital gains, investment income, and reinvestment to estimate total returns. YTM is the culmination of a complex set of calculations that discounts future principal and interest cash flows. We use various combinations of bond tables, financial calculators, and the Microsoft Excel RATE function to calculate yield-to-maturity.

In any event, preferred shares and bonds are highly susceptible to inflation, interest rate, and opportunity cost risks. Safety of principal is somewhat of an oxymoron, as inflation ravages long-term purchasing power.

Hybrid Securities

If nothing else, Wall Street is creative in engineering product to push out the door deep into the Financial Universe. Hybrid securities combine elements of debt and equity – to help sophisticated investors better negotiate risks versus rewards.

Participating preferred, convertible preferred stock, and convertible bonds do add more wrinkles to the asset class mix. Hybrid securities clear a pathway for conservative savers to possibly benefit from strengthening corporate profits, while still regularly taking in hefty investment income.

Participating preferred shareholders are promised dividend increases, in the event that corporate financials exceed predetermined sales and profitability metrics. And as their names would imply, convertible preferred shares and convertible bonds may each be exchanged for shares of common stock at set rates.

Investors will trade in convertible stock and bond holdings when common shares price out significantly above parity. Corporation Z, for example, offers preferred shares convertible to common at two to one. Corporation Z will be at parity at $50 and $100 for preferred and common, respectively.

Convertible securities often times double as built-in poison pills to thwart hostile takeovers. One outside shareholder who accumulates a large percentage of outstanding common stock will trigger the poison pill. Convertible preferred stock and bonds would then automatically be exchanged for massive amounts of common shares, which would then make any prospective acquisition prohibitively expensive.

Controversial poison pills, of course, are staggeringly dilutive for existing shareholders and might even destroy long-term value by blocking new and more capable management.

Financial Strategy

For retail clients, a diversified portfolio featuring cash, bonds, shares of common stock, and owner-occupied real estate will be sufficient to build real wealth, while also mitigating downside risks. Onyx Investments will typically recommend a gradual shift out of equities and into credit securities over time.

Corporations that make for good, preferred stock investments, make for even better common stock investments through fundamental analysis.

Preferred shares are best reserved for sophisticated investors working through special situations. In 2011, Warren Buffett struck a sweetheart deal to purchase $5 billion in Bank of America preferred stock paying 5% dividends to Berkshire Hathaway. These preferred shares were also redeemable at a 5% premium and were attached to warrants granting rights to buy 700 million shares of Bank of America common stock at $7.14. In 2017, the Oracle of Omaha cashed out his $5 billion preferred shares and exercised all B of A warrants.

Bank of America stock now trades for $35.55 per share and is worth a cool $36.7 billion on the Berkshire Hathaway balance sheet.

Easy work if you can get it.