The Complete Guide
Preferred Stock Investing Guide
How preferred stocks work, how to evaluate them, and why I concentrate on GSE junior preferred shares. The hybrid security that most investors overlook — and should not.
Why I Know Preferred Stocks
I have been concentrated in Fannie Mae and Freddie Mac junior preferred shares since 2013. I learned preferred stock analysis the hard way — by putting real money into securities where the difference between par value and market price represented the opportunity of a lifetime, or the risk of total loss.
Benjamin Graham devoted extensive sections of Security Analysis to preferred stock evaluation — coverage ratios, asset backing, and the hierarchy of claims. My approach is directly derived from Graham's framework.
See my current positions and track record for where this knowledge meets real money.
How to Invest in Preferred Stock — Step by Step
From understanding the basics to placing your first order.
Understand What Preferred Stock Is
Preferred stock is a hybrid security that sits between bonds and common stock. It has a fixed par value (typically $25), pays a fixed dividend (like a bond coupon), and has priority over common stock in dividend payments and liquidation. Unlike bonds, preferred dividends are not guaranteed — they can be suspended, though this is relatively rare for investment-grade issuers.
Learn the Key Terms
Par value: the face value of the share, typically $25 or $50. Coupon rate: the annual dividend expressed as a percentage of par value. Cumulative: missed dividends accumulate and must be paid before common dividends resume. Non-cumulative: missed dividends are lost forever. Callable: the issuer can redeem shares at par after a specified date. Convertible: can be converted to common shares at a specified ratio.
Choose Your Preferred Stock Type
Traditional preferreds pay a fixed coupon and trade near par in normal conditions. Floating-rate preferreds adjust their dividend based on a benchmark rate. Convertible preferreds can be exchanged for common stock. Trust preferreds (TRuPS) are issued by bank holding companies. Each type has different risk/reward characteristics.
Evaluate Credit Quality
Preferred stocks carry credit risk. If the issuer goes bankrupt, preferred holders stand behind bondholders but ahead of common shareholders. Check the issuer's debt-to-equity ratio, interest coverage ratio, and credit ratings. For banks and financial institutions, look at Tier 1 capital ratios. Benjamin Graham's coverage ratio analysis from Security Analysis applies directly here.
Calculate Current Yield and Yield-to-Call
Current yield = annual dividend / current market price. If a $25 par preferred with an 8% coupon trades at $20, the current yield is $2.00 / $20.00 = 10%. But if it is callable in 2 years, the yield-to-call might be different. Always calculate both metrics. Never buy a preferred trading above par that is callable soon — you will lose the premium when it gets called.
Place Your Order and Manage Risk
Most preferreds trade on the NYSE or OTC markets. Use limit orders — spreads can be wide, especially for lower-volume issues. Diversify across issuers and sectors unless you have deep expertise in a specific name (as I do with GSE preferreds). Monitor interest rate sensitivity — when rates rise, preferred prices typically fall, since their fixed dividends become less attractive relative to new issues.
Preferred Stock vs. Common Stock
| Feature | Preferred | Common |
|---|---|---|
| Priority in Liquidation | Higher — paid after bondholders but before common | Last — after all debt and preferred holders |
| Dividends | Fixed rate, often cumulative (missed dividends accrue) | Variable, declared by board, no obligation |
| Upside Potential | Limited — trades near par value | Unlimited — grows with the business |
| Voting Rights | Typically none (sometimes in default scenarios) | Yes — one vote per share typically |
| Price Volatility | Lower — anchored to par value and interest rates | Higher — driven by earnings, growth, and sentiment |
| Tax Treatment | Qualified dividends for most domestic issues (lower tax rate) | Qualified dividends + capital gains on sale |
GSE Preferred Stocks: A Case Study
The Opportunity
Fannie Mae and Freddie Mac junior preferred shares represent the ultimate special situation in preferred stock investing. Shares with $25 par values and 6-8% coupons have traded at deep discounts during the conservatorship. If privatization happens and preferred shareholders are made whole, these shares return to par with back dividends. This is Graham and Dodd analysis applied to a real-world situation.
Key Series to Know
Full deep dive on GSE preferred shares · How to invest in Fannie Mae · Privatization timeline
Essential Reading for Preferred Stock Investors
Security Analysis
Benjamin Graham & David Dodd
Graham literally wrote the framework for analyzing preferred stocks. Coverage ratios, asset backing, and the hierarchy of claims.
Preferred Stock Investing
Doug K. Le Du
The most comprehensive modern guide to preferred stock investing. Covers selection criteria, tax implications, and portfolio construction.
Frequently Asked Questions
What is a preferred stock?
A preferred stock is a type of equity security that has characteristics of both stocks and bonds. It has a fixed par value (usually $25), pays a fixed dividend, and has priority over common stock in dividend payments and asset distribution if the company is liquidated. Unlike bonds, preferred dividends can be suspended, but unlike common dividends, they are typically cumulative — meaning missed payments must be made up before common shareholders receive anything.
Is preferred stock a good investment?
Preferred stock can be an excellent investment for income-focused investors seeking yields higher than bonds with less volatility than common stock. The key is buying at the right price relative to par value and evaluating the credit quality of the issuer. In special situations — like GSE preferreds during the conservatorship — preferred stocks can also offer significant capital appreciation potential.
What is the difference between preferred stock and common stock?
Preferred stock pays a fixed dividend, has a defined par value, and has priority over common stock in liquidation. Common stock has unlimited upside potential, voting rights, and variable dividends. Preferred stockholders get paid first but have limited upside; common stockholders get paid last but have unlimited upside. In a restructuring, this priority becomes critically important.
How are preferred stock dividends taxed?
Most preferred stock dividends from U.S. corporations qualify for the lower qualified dividend tax rate (0%, 15%, or 20% depending on your income bracket), rather than the ordinary income tax rate. This makes them more tax-efficient than bond interest, which is taxed as ordinary income. However, preferred dividends from REITs and foreign corporations may not qualify for this treatment.
What happens to preferred stock when interest rates rise?
When interest rates rise, preferred stock prices typically fall. This is because preferred stocks pay fixed dividends — as new issues come to market with higher yields, existing preferreds become less attractive. The longer the duration (time to call date), the more sensitive to rate changes. Floating-rate preferreds are partially insulated from this risk because their dividends adjust with benchmark rates.
What are GSE preferred stocks?
GSE preferred stocks are preferred shares issued by Fannie Mae and Freddie Mac (Government-Sponsored Enterprises). Popular series include FNMAS, FMCKJ, FMCCS, and FMCCJ. These trade on the OTC market and are a special situation investment tied to the outcome of the conservatorship that began in 2008. They have fixed par values ($25 or $50) and dividend coupons that are currently suspended but would resume upon privatization.
Tools for Preferred Stock Investors
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