1. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? A preferred stock is a security that combines some of the features of both bonds and common stocks. –Most do not carry voting rights. –They have a preferred position with respect to the earnings of a corporation. Dividends on preferred stocks must be paid before any dividends can be paid to holders of common shares. Owners of preferred stock have precedence over common stockholders with respect to the assets of the corporation in the event of a sale or liquidation of the company.

2. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 When is the use of this tool indicated? When a current rate of return on investment at a rate higher than that available from the same company’s common stock is desired When a fixed amount and steady flow of income is needed –Most preferred stocks pay: A fixed dollar amount of dividend, or A dividend based on a stated percentage of the preferred stock’s par value. –Example: Assume Citigroup has a 7% preferred stock issue outstanding. The stock pays a quarterly dividend of 44 cents per share in January, April, July, and October.

3. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 When is the use of this tool indicated? When the purchaser of the stock is a corporation –Generally, a corporation is entitled to deduct 70% of the dividends it receives from other domestic corporations from its taxable income. Only 30% of the dividends received are subject to federal income tax Current law allows accumulations of up to $250,000 ($150,000 for most professional corporations) even if the corporation is used to avoid personal income tax by allowing preferred dividends to accumulate at favorable corporate rates. When there is no particular date on which the investor must have his capital returned. –Preferred stocks have no maturity date. –Investors must sell their preferred shares to regain their capital.

4. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 Advantages Income from preferred shares is relatively certain. –Typically, preferred dividends are paid on a quarterly basis. –They must be paid before any common shareholders can receive dividends. –Generally, preferred shares have a “cumulative” nature. Any preferred dividends that are “passed” must be accumulated by the corporation and eventually paid before any dividends can be paid to common shareholders. The investor’s capital is relatively secure. –After bondholders and other creditors, preferred shareholders take precedence over common shareholders in the event of a corporate sale or liquidation.

5. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 Advantages The prices of preferred stocks tend to be more stable than those of common stocks. –They are more likely to reflect changes in interest rates, which are relatively less volatile than changes in the earnings of a corporation. When interest rates decline, the prices of preferred shares tend to increase, and vice versa. Because preferred stocks have no maturity date, they resemble very long-term bonds in terms of significant fluctuations for any given change in rates. Some preferred stocks are “convertible.” –They may be exchanged at a predetermined rate for common stock of the same corporation. –Allows participation in equity growth

6. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 Disadvantages The purchasing power of future fixed preferred stock dividends may be eroded by inflation. –The longer the holding period of the investment, the more likely that the purchasing power of each fixed dollar payment will decline. Dividend payments on preferred stock will not increase even if the financial condition of the company or the economy improves. –Some preferred stocks are “participating” issues. Preferred stockholders may be entitled to payments above the normal level of dividends in certain situations. This occurs once common stockholders received dividends of a specified amount. Preferred stocks do not provide much opportunity for capital growth.

7. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 Tax Implications Dividends received on preferred stocks are generally taxable at ordinary income rates. –Under JGTRRA 2003, “qualified dividend income” is treated as net capital gain and is subject to lower tax rates. For taxpayers in the 25% income tax bracket and higher, the maximum rate on qualified dividends paid by corporations to individuals is 15% in 2003 through 2010. After December 31, 2010, dividends will once again be taxed at ordinary income tax rates. –Qualified dividend income does not include certain preferred stock dividends where the “dividend” paid on the preferred stock is structured and treated as debt by the company.

8. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 Tax Implications Profits on the sale of preferred shares are long-term or short-term capital gains depending on the holding period. –Net capital gains are: The excess of long-term capital gains over short-term capital losses Generally taxable at a maximum rate of 15% through 2010 Losses on the sale of preferred stock are subject to capital loss rules. –Certain limits are imposed on the utility of capital losses in offsetting ordinary income. –Unused capital losses may be carried forward by individuals and applied against future income.

9. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 Tax Implications If a share of preferred stock is sold at a loss and then repurchased within a given time period, the investment will be subject to the so- called “wash sale” rules. If received by a corporate investor, dividends received on preferred stocks of domestic corporations are subject to the “dividends received” deduction. –Up to 30% of the dividend will be subject to corporate tax rules. Preferred stocks held at death in the sole name of the investor will be subject to both federal and state death taxes. –Fifty percent of preferred stocks held jointly between spouses will be includable in the gross estate of the first joint owner to die but will generate no federal estate tax because of the unlimited marital deduction.

10. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 Alternatives Government, municipal, or corporate bonds –Generally provide many of the same characteristics of high quality preferred stocks –Investors should consider bonds that generate a comparable or higher after-tax yield. Convertible bonds –A viable substitute for convertible preferred stocks of the same or similar companies

11. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 Alternatives Single premium deferred annuities providing a fixed annual payment –Until the annuity payout period begins, this alternative may not be suitable. –Unless the annuity has a guaranteed payout or a joint and survivor provision, the value of the annuity will terminate at the owner’s death and provide no benefit to heirs.

12. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 Where and How do I get it? Preferred stocks may be purchased directly through a brokerage firm, as well as banks that offer brokerage services. –Discount brokerage houses are also available. Many preferred stocks are listed on organized stock exchanges, such as the New York or American stock exchanges. –They are shown immediately below the listings for the same company’s common stock. –However, the majority of preferred issues are unlisted and trade on the over-the-counter market.

13. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 Where and How do I get it? Trading is dominated by corporations and other institutional investors. –The availability of the dividends received deduction to corporate investors tends to work against individual investors. –The market is not as active as the market for common shares. –Trading volume is relatively low. Indirect investment in preferred stocks is available through the purchase of shares in a mutual fund. –Income funds, which emphasize a high rate of current return on investment, frequently purchase large blocks of preferred stock. –The mutual fund approach offers diversification and professional management in addition to high yield and relative price stability.

14. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 What fees or other costs are involved? When purchased through a broker, a regular sales commission is added to the price of the preferred shares. –This brokerage commission is typically 2 to 3% of the value of the shares purchased. Banks and discount brokers may charge a flat fee. –$10 to $40 for buying shares, or –A fee based on the number of shares purchased regardless of price. In the case of mutual funds, a regular sales fee will apply in the case of a “load” fund. –No sales charge is added to the purchase price of shares in a “no- load” fund. –Both types will normally charge a management fee and an account maintenance fee.

15. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 How do I select the best of its type? The financial condition of the issuer is of primary concern. –The company’s earning record Particularly the growth of earnings or at least a pattern of stable earnings during the past 10 years –Earnings available to pay preferred dividends should be several times the amount actually required. Preferred stockholders do not have first claim on a company’s earnings. –Earnings are first used to pay any interest due to bondholders. –The company should have enough earnings to pay interest and dividends even if earnings should decline for a year or two. “Margin of Safety” –Since preferred dividends will not be increased no matter how prosperous the firm may be, the investor must be more concerned with the payment of those dividends under the worst of circumstances.

16. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 How do I select the best of its type? The financial condition of the issuer is of primary concern. –The liquidity of the company Important because preferred dividends are paid from cash An attractive company will have a substantial cash position as well as large amounts of short-term assets. –The preferred stock issue should be relatively small compared with other capital of the firm. The amount of preferred dividends will be a small obligation compared with bond interest or common dividends. The relatively small size adds to the overall security.

17. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company17 How do I select the best of its type? Investors should compare the dividend yield available from a preferred stock with other issues of apparent similar quality. –One issue offering a substantially higher return over other similar issues may indicate excessive risk. Investors may want to compare the yields available from bonds as an alternative to preferred stock. –Bonds provide a greater degree of security. Interest payments must be made in order for the firm to avoid bankruptcy. –Preferred dividends can be passed, or deferred, even if they are cumulative. This may be difficult for investors who are dependent on a regular flow of investment income

18. Preferred Stocks Chapter 11 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company18 Where can I find out more about it? Publications from Standard and Poor’s and Moody’s Investors Services are available at most local libraries. –These will provide information on the issuing companies as well as the historical record of any preferred stocks. Major Brokerage Firms –Typically can provide information on specific issues as well as current market conditions that may or may not make preferred stocks attractive for investment. Annual report on the company in question –Can provide details on the issue itself as well as the overall financial condition of the company