Preferred stock: Is it a good option?

NEW YORK — When a company’s balance sheet is in tatters, is an investor any better off holding preferred stock?

It’s a question that’s coming up more often these days, as struggling corporations slash dividends, issue stock offerings to raise cash and, in many cases, file for bankruptcy.

Amid all the uncertainty, investors might wonder how they can become a preferred shareholder and what added risks and benefits that title brings.

Of course, many don’t even know what preferred stocks are.

That’s understandable, considering they’re a lot less common than other investment options. The total market value of preferred stocks trading in the U.S. was about $100 billion last year, according to Standard &Poor’s — barely more than 1 percent of the $9.5 trillion stock market.

The details can be complex, but here are some questions and answers about preferred stocks.

Question: First of all, the basics: What is a preferred stock?

Answer: To get a grasp of how preferred stocks work, it helps to understand common stocks, as well as bonds.

A common stock is essentially an ownership share in a publicly traded company. Your gain or loss depends primarily on whether the price of the stock rises above or falls below what you paid, meaning it can be a risky investment.

The value of a common stock is also sensitive to any number of factors, including speculation about the company’s health, new government regulations or general investor sentiment about the economy.

A bond, meanwhile, is a loan an investor makes to a public entity in exchange for a fixed interest rate payment. This is regarded as considerably more stable, although the potential for big gains is also limited.

A preferred stock is essentially another type of security issued by companies to raise capital from investors. It acts like a hybrid of a common stock and a bond, with its riskiness typically falling somewhere between the two.

As a preferred shareholder, you have greater rights to a company’s assets than a common stockholder in the case of a bankruptcy. But share prices for preferred stocks historically haven’t moved up and down as dramatically as common stocks with companies’ rising and falling fortunes, meaning there’s less potential for big gains and losses.

The advantage of preferred shares is that they pay fixed dividends — regular payments to investors that are separate from gains that are based on rising share prices. In that respect, a preferred share mimics a bond.

Of course, last year was an exception. Share prices of preferred stocks, like common stocks, suffered massive losses on concerns over the health of the issuing companies.

Q: How do I invest in preferred shares?

A: Like common stocks, preferred stocks are sold on exchanges for a share price. They have their own tickers, usually a variation of the ticker for the company’s common stock. They also have their own share prices.

You can buy preferred shares the same way you buy common stock — through a broker or on a trading Web site such as E-Trade.

Q: What are the reasons for buying preferred stocks?

A: In normal market conditions, the return on a preferred stock is generally higher than a bond, at around 6 percent. At the same time, share prices aren’t as volatile as with common stocks.

“Most people buy (preferred stocks) because they’re looking for additional yield in their portfolio and they’re willing to take on a little more risk than with a bond,” said Alyce Zollman, a financial consultant with Charles Schwab &Co.

Q: How risky are preferred stocks?

A: Until last year, one attraction of preferred stocks was that share prices were so much more stable than for common stocks. But as financial companies ran into unprecedented troubles last year, both types of stock plummeted.

The market value on preferred shares was about $214 billion in 2007; the figure plunged to $100 billion in 2008, according to Standard and Poor’s. Srikant Dash, head of research and design at S&P, said most of those losses have since been recovered.

Despite the recent ups and downs, the return on preferred shares should still outpace that of bonds over a longer time frame of even a few years, Zollman said. The catch is the greater risk of volatility in the meantime.

As such, Zollman said preferred shares shouldn’t be used to help generate a regular fixed income.