Preferred Stock Strategy

Preferred stock dividends can be either qualified or ordinary, depending on the issuer and specific terms:

Generally:

• Traditional Corporate Preferreds: Often pay qualified dividends taxed at lower rates (0%, 15%, or 20%)
• REIT Preferreds: Typically pay non-qualified dividends taxed as ordinary income
• Bank Preferreds: Often structured as trust preferred securities (TruPS) which may pay non-qualified dividends
• MLP Preferreds: Pay return of capital distributions (tax-deferred)

How to Determine:

• Check the Prospectus: Look for dividend classification in offering documents
Form 1099-DIV: Brokerage statements categorize dividends in Box 1b (qualified) vs Box 1a (ordinary)
• Issuer Guidance: Many issuers provide tax information on investor relations websites
• Holding Period: To receive qualified treatment, you must hold the preferred for more than 90 days during the 181-day period beginning 90 days before the ex-dividend date

Tax Strategy: For tax efficiency, consider holding preferreds with non-qualified dividends in tax-advantaged accounts (IRAs, 401ks) and those with qualified dividends in taxable accounts.

When an issuer exercises its call option on preferred stock:

The Process:

• Call Notice: Issuer announces call date and call price (usually par value: $25 or $1000)
• Final Dividend: You receive the final dividend up to the call date
• Payment: On the call date, you receive the call price per share
• Position Closure: The shares are removed from your account

Investor Implications:

• Reinvestment Risk: You must reinvest the proceeds, often at lower prevailing yields
• Capital Gain/Loss: Difference between your purchase price and call price creates taxable event
• Yield-to-Call vs Current Yield: The effective yield if called may differ from current yield
• Call Protection Ends: No further dividends after call date

Example: You buy a $25 par preferred at $26 yielding 6%. It's called at $25. You receive:

• Final dividend payment
• $25 per share (call price)
• $1 capital loss per share ($25 - $26 purchase price)

Strategies:

• Buy Below Par: Purchase below call price to avoid capital loss if called
• Monitor Call Dates: Track upcoming calls to plan reinvestments
• Consider Non-Callable: Some preferreds are non-callable or have long call protection
• Calculate Yield-to-Call: Compare current yield to yield if called at next call date

This is a critical distinction that significantly impacts risk:

Cumulative Preferred:

• Accumulation: Missed dividends accumulate and must be paid before any common dividends
• Payment Priority: All accumulated dividends must be paid before resuming common dividends
• Investor Protection: Higher level of dividend security
• Yield: Typically lower yields than non-cumulative (less risk)
• Examples: Most utility and industrial preferreds

Non-Cumulative Preferred:

• No Accumulation: Missed dividends are gone forever
• Payment Discretion: Issuer can resume dividends without paying missed amounts
• Higher Risk: Dividend stream less secure
• Yield: Typically higher yields than cumulative (more risk)
• Examples: Most bank and financial preferreds (especially post-2008)

Regulatory Context for Banks:

• Basel III Rules: Require bank capital instruments (including preferreds) to be non-cumulative to qualify as Additional Tier 1 capital
• Stress Test Scenarios: Banks can suspend dividends on non-cumulative preferreds during financial stress
• Investor Impact: Higher yield compensates for higher risk of dividend suspension

Investment Considerations:

• Risk Tolerance: Conservative investors should prefer cumulative preferreds
• Yield Requirements: Those needing higher income might accept non-cumulative risk
• Sector Allocation: Be aware that most bank preferreds are non-cumulative
• Economic Outlook: Non-cumulative risk increases during economic downturns

Preferred stocks are highly sensitive to interest rate changes, similar to bonds:

Fixed-Rate Preferreds:

• Price Movement: Prices move inversely to interest rates (rates up = prices down)
• Duration Effect: Longer duration preferreds (those with distant call dates or perpetual) are more sensitive
• Yield Comparison: As new issues offer higher yields in rising rate environments, existing preferreds must drop in price to remain competitive
• Example: A 6% fixed-rate preferred trading at $25 will drop to ~$23.81 if new issues yield 6.3%

Floating-Rate Preferreds:

• Price Stability: More stable as dividends adjust with benchmark rates
• Adjustment Mechanism: Dividends reset periodically (quarterly, semi-annually) based on LIBOR, SOFR, or Treasury rates plus a spread
• Lower Sensitivity: Much less price volatility in changing rate environments
• Trade-off: Typically offer lower initial yields than fixed-rate preferreds

Investment Strategies by Rate Environment:

• Rising Rates:
  • Focus on floating-rate preferreds (PFFR, PFXF)
  • Shorten duration by selecting preferreds with near-term call dates
  • Consider preferreds trading below par (less downside if called)
  • Use dollar-cost averaging to buy during price declines
• Falling/Stable Rates:
  • Focus on fixed-rate preferreds with long call protection
  • Lock in higher yields for longer periods
  • Consider preferreds with higher coupons that may be called
  • Evaluate capital appreciation potential as prices rise

Convertible preferreds offer unique benefits but with trade-offs:

Key Features:

• Conversion Right: Can be converted into common stock at a predetermined ratio (conversion ratio)
• Conversion Price: The price at which conversion becomes attractive (usually above current common price)
• Dividend Advantage: Higher dividend than common stock while held as preferred
• Upside Participation: Can benefit from common stock appreciation through conversion
• Downside Protection: Floor at preferred value if conversion isn't beneficial

Advantages:

• Income + Growth: Combines preferred dividend income with common stock upside
• Lower Volatility: Typically less volatile than common stock (trades closer to bond characteristics)
• Priority Position: Higher claim on assets than common shareholders
• Call Protection: Often have strong call protection features
• Tax Efficiency: Dividends often qualified, conversion may create tax-deferred gains

Disadvantages:

• Lower Yield: Typically lower dividend than traditional preferreds (3-6% vs 5-8%)
• Complex Valuation: Requires understanding both preferred and option pricing
• Dilution Risk: Conversion dilutes common shareholders
• Conversion Premium: Usually trade at a premium to conversion value
• Limited Issuers: Fewer companies issue convertible preferreds

When to Consider Convertible Preferreds:

• When you want exposure to a company's growth but with income
• In volatile markets where downside protection is valuable
• When you believe the common stock will appreciate significantly
• As part of a diversified income portfolio for growth potential
• When current yields on traditional preferreds are low relative to growth prospects

Preferred stocks can play a valuable role in retirement portfolios with proper allocation and selection:

Benefits for Retirees:

• Higher Income: 5-8% yields boost retirement cash flow
• Priority Payments: Dividends paid before common stock dividends
• Lower Volatility: Generally less volatile than common stocks (though more than bonds)
• Inflation Protection: Some have floating rates or periodic resets
• Diversification: Different risk/return profile than stocks and bonds

Retirement Allocation Guidelines:

• Conservative (Low risk): 5-10% of fixed income allocation
• Moderate: 10-20% of fixed income allocation
• Aggressive (Higher income need): 20-30% of fixed income allocation
• Maximum Practical: Generally not more than 30% of fixed income due to call and interest rate risks

Retirement-Specific Strategies:

• Ladder Approach: Create a ladder of preferreds with staggered call dates for consistent income
• Focus on Cumulative: Prefer cumulative preferreds for more secure income stream
• ETF Foundation: Use preferred ETFs (PFF, PGX) as core holdings for diversification
• Tax Location: Hold preferreds with non-qualified dividends in IRAs, qualified in taxable accounts
• Inflation Protection: Include some floating-rate preferreds for rising rate environments

Special Considerations for Retirees:

• Sequence of Returns Risk: Be cautious of price declines early in retirement - consider dollar-cost averaging into positions
• Call Risk Management: Monitor call dates closely to avoid forced reinvestment at inopportune times
• Liquidity Needs: Ensure sufficient liquid assets outside preferred holdings for unexpected expenses
• Professional Management: Consider preferred CEFs or ETFs for professional call risk management
• Credit Quality Focus: Prioritize investment grade (BBB- or higher) preferreds for retirement stability

Tax treatment varies significantly based on preferred type and structure:

Dividend Taxation:

• Qualified Dividends: Taxed at preferential rates (0%, 15%, or 20%) based on income
• Non-Qualified Dividends: Taxed as ordinary income (10-37% based on bracket)
• REIT Preferreds: Typically non-qualified, may include return of capital
• Bank Preferreds (TruPS): Often non-qualified due to trust structure
• MLP Preferreds: Return of capital (tax-deferred), reduces cost basis

Capital Gains/Losses:

• Sale or Call: Difference between sale/call price and cost basis creates capital gain/loss
• Holding Period: Long-term (>1 year) vs short-term gains rates apply
• Wash Sales: Rules apply if repurchasing substantially identical security within 30 days
• Market Discount: If purchased below par, portion of gain may be ordinary income

Special Tax Considerations:

• Original Issue Discount (OID): Some preferreds issued below par - portion of dividends may be treated as return of principal
• Market Discount: Purchasing below par in secondary market creates market discount, taxed as ordinary income upon sale/call
• Premium Amortization: Purchasing above par may allow amortizing premium against dividend income
• Foreign Tax Credit: Foreign preferreds may have withholding taxes eligible for credit

Tax Optimization Strategies:

• Account Placement:
  • Taxable Accounts: Qualified dividend preferreds
  • IRAs/401(k)s: Non-qualified dividend preferreds
  • Roth Accounts: Highest growth potential preferreds
• Tax-Loss Harvesting: Use price declines to realize losses offsetting other gains
• Holding Period Management: Ensure >90 day holding for qualified treatment
• Professional Guidance: Consider tax professional for complex situations or large holdings
• Record Keeping: Maintain detailed records of purchases, sales, calls, and dividend classifications