With the stock market facing its first bear market since 2008, investors are scurrying to seek out investments that can hold their own amid dramatic levels of uncertainty. With the COVID-19 pandemic continuing to affect rising numbers of patients around the world, it's been increasingly difficult for investors to find shelter -- even in some traditionally reliable safe-haven investments.
Many investors aren't familiar with preferred stock, but it has some advantages that can be appealing during broader market downturns. With some features of regular stocks and some features of bonds, preferred stock can be a less risky alternative that can provide portfolio income. But as some investors have learned the hard way recently, even preferred stock has its risks. Below, we'll look more at what preferred stocks are and how they've fared during the bear market.
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All in a name
Preferred stock is primarily an income-producing investment, but unlike bonds, it's treated as equity for purposes of determining how much investors get if a company liquidates. When a business fails, any remaining assets first go to pay off bondholders and other creditors. Only if anything's left do shareholders get anything. One advantage preferred shareholders get is that they typically receive a fixed amount of remaining assets before regular shareholders get anything.
The other advantage that preferred stock has is that it gets preferential treatment with respect to dividend payments. A company can't pay a dividend to its common shareholders unless its preferred shareholders receive their dividends in full. Sometimes, a company even guarantees that if it skips a dividend payment to preferred shareholders, it'll make those investors whole in the future before paying a dividend to common shareholders.
Because of these advantages, preferred stock is somewhat safer than common stock. However, those advantages come at a price: Preferred shareholders usually have to let the company buy back their shares at a fixed point in the future for a certain price. That limits the ability of preferred stock to grow in value. That loss of upside is the trade-off preferred stock investors accept to get their downside protection.
How preferred stocks behave in a credit crunch
As long as a company's viability as an operating business isn't in question, preferred stocks tend to stay relatively stable and make their regular dividend payments on time and in full. When people start to question whether companies will survive, however, even preferred stocks can see declines in price.
We've started to see that happen recently. iShares Preferred and Income Securities (PFF), an exchange-traded fund (ETF) that holds considerable amounts of preferred stock, has seen dramatic levels of volatility. Although the preferred-stock ETF largely got through the first couple of weeks of the broader stock market decline unscathed, its shares suffered a 10% decline on March 12. Sharp moves in both directions ensued, including declines of 10% on March 16 and 17% on March 18 followed by a 10% rebound on March 19.
The big moves came amid rising doubt about what exposure financial institutions have to bank loans that are likely to default if the coronavirus crisis continues well into the future. The sharp drop in bank preferred-share prices suggests that investors believed that those loans represented a systemic threat to the financial system. Given the perturbations that bond market investors have had to endure in recent weeks, it's not surprising to see similar disruptions showing up in the much less liquid preferred stock market.
Look for opportunity
When prices fall dramatically, there's often a chance for smart investors to take advantage of irrational market moves. That's especially the case among preferred stocks, which don't have nearly as wide a following among investors as regular stocks do.
Whether you decide to go with individual preferred stocks or use an ETF, though, you need to understand the risks involved with these investments before you invest. Right now, few investors feel confident about whether the COVID-19 pandemic will require a lot more liquidity than most businesses have on hand. If the crisis goes on much longer than expected, then preferred stocks could give you a nasty surprise -- especially if the second-order effects of coronavirus on the financial system prove to be more harmful than currently thought.
