Preferred Stock Investing Risks
Preferred stock investing can seem like a low-risk alternative to common stocks, but it also comes with its own set of potential risks and pitfalls. While preferred shares often have a higher credit rating than their common counterparts, they are still debt-like instruments that carry the possibility of default if the issuing company faces financial difficulties.
The Risk of Default
One of the primary risks associated with investing in preferred stock is the possibility of default by the issuing company. Since preferred shares represent a type of debt, investors are entitled to priority over common shareholders in terms of dividends and assets in the event of liquidation. However, this also means that if the company defaults on its obligations, preferred shareholders will be at the front of the line when it comes to losses.
Credit Risk
As with any debt instrument, there is a risk associated with the creditworthiness of the issuer. If the company's financial situation deteriorates or it experiences difficulties meeting its debt obligations, the value of the preferred stock may decline sharply. This can result in significant losses for investors who purchased the shares at face value.
Callable Preferred Stock
Another risk to consider is that preferred stock is often callable by the issuing company. This means that if interest rates drop, the company may be able to refinance its debt more cheaply and call back the existing preferred shares. While this can result in a quick profit for investors who sell their shares before they are called, it also represents a risk of unexpected capital losses.
Inflation Risk
Preferred stock investments can also be affected by inflation. If interest rates rise due to an increase in inflation, the value of the preferred stock may decline as new, higher-yielding investments become more attractive. This can result in a decrease in the market price of the preferred shares, making them less valuable than they were initially.
Regulatory Risks
Finally, investors in preferred stock should be aware of regulatory risks that could impact the company's ability to meet its debt obligations. Changes in laws or regulations that affect the company's business model or financial situation can result in a decline in the value of the preferred shares.