Passive Income Vol. 3: Preferred Stock

Not quite a bond, and not really equity, preferred stock sits between these two major portfolio building blocks in the capital stack. So why should you consider adding preferred stock to your portfolio?

Preferred equity holders have priority over common stock when it comes to dividends. This is attractive to dividend investors worried that their payouts may be cut or eliminated if the company runs into cashflow issues. The share price of preferred stock also tends to be less volatile than its common equity counterpart, reducing overall volatility in the portfolio.

One common preferred stock fund is PFF. It has an expense ratio of 0.46% and a dividend yield of 6.54%. The table below compares 10yr performance and metrics against FBNDX, the Fidelity Investment Grade Bond Fund.

PFF outperformed FBNDX over the past 10yrs with a similar fee.

Some advantages of preferred stock:

1) Usually higher dividends than common stockholders

2) They often pay "qualified" dividends, which are taxed at the lower capital gains rate, rather than ordinary income rate

3) Diversification benefits from other kinds of bonds

Some disadvantages of preferred stock:

1) Limited upside of share price appreciation

2) Subordinate to bonds in bankruptcy

3) Limited liquidity on individual preferred names