TAKING STOCK: The difference between preferred stock and common stock

Dear Mr. Berko:

My stockbroker wants me to invest $10,000 by buying 400 shares of Energy Transfer Partners’ 7.625 percent low-rated preferred stock, which sells for $25.33 a share. I can afford the risks of low-rated issues, and the income, which is my prime goal, looks very good. But I’ve never owned a preferred stock, so please tell me how preferred stocks differ from common stocks.

MP, Akron, Ohio


Dear MP:

Both common stock and preferred stock represent ownership in a company. But an important difference between the two is that holders of the common can vote their shares, whereas the preferred owners usually have no voting rights. Another difference is that preferred shareholders have a fixed dividend, whereas dividends for common shareholders are at the discretion of the board. They can be raised, reduced or eliminated.

Preferred shares also have a prior claim to the company’s assets and earnings. So preferred stock dividends must be paid before common stock dividends. When a company declares bankruptcy or becomes insolvent and must liquidate its assets, it first pays creditors, and then it pays bondholders, and then it pays preferred shareholders. Common shareholders are last in line to collect assets and hardly get a pfennig.

The dividend yield on a preferred stock is calculated as a percentage of the preferred’s market price, just like the dividend yield on a common stock. Preferred shares trade just like common shares. But preferred shares have a call feature allowing the company to redeem the shares. Preferred shares are always redeemed at a predetermined price, which is often a small premium over their original issue price. Preferred stocks also tend to be stabler in price than common stocks because preferreds pay regular and known dividend streams, whereas the dividends of common stocks can fluctuate. Steady dividend payments from a preferred issue can be more attractive to investors seeking income dependability and continuity, whereas the potential for capital gains with a common stock is more attractive to other investors.

Now, I don’t like and have never liked fixed-income investments. When interest rates rise—and they may continue increasing over the coming few years—the market value of a fixed-rate investment will fall. And if inflation pushes consumer prices higher (as it appears to be doing), the market value of a fixed-income investment will decline. Simply put, if $1,000 of dividends will buy 400 gallons of regular gasoline today, that same $1,000 of dividends may buy only 350 gallons of regular fuel two years hence. Even Einstein and Churchill, my two Maine coons, understand that. So buying fixed-income investments in an environment of rising inflation and interest is just plain bloody stupid.

Your broker is recommending a better way to own a preferred stock. Energy Transfer Partners offers a floating-rate preferred that provides protection against rising rates. His recommendation is the company’s 7.625 percent Series D fixed-to-floating preferred units (ETP-D-$25.33), which came public in July at $25 a share. The following explanation may be tricky, so read it out loud and slowly.

Between now and Aug. 15, 2023, the Series D shares will pay 7.625 percent of the $25 IPO price. So for five years, an investor will earn a 7.625 percent current yield from this BB-rated issue. Then, on Aug. 15, 2023, the dividends will float at a rate equal to the three-month London Interbank Offered Rate plus 4.738 percent. So if Libor were to be 4 percent on Aug. 16, the D shares would pay 8.738 percent. If Libor were to rise to 5 percent, the D shares would pay 9.738 percent. But if Libor were to fall to 1 percent, an investor’s yield would fall to 5.738 percent. Today Libor is 2.34 percent. It has averaged 3.79 percent since 1986. Libor hit an all-time high of 10.63 percent in March 1989 and a record low of 0.22 percent in May 2014.

These shares have no maturity date but are callable at the option of the issuer on Aug. 15, 2023, at $25. Meanwhile, 19 analysts follow Energy Transfer Partners’ common stock, and 15 have a “buy” rating.
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Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at mjberko@yahoo.com. To find out more about Malcolm Berko and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.

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