Understanding Preferred Stocks and Interest Rate Movements
When interest rates rise, the stock market, like much of the investment world, is likely to experience a downturn. This is a critical consideration for all investors, and especially for those who hold preferred stocks. Understanding how preferred stocks behave in such an environment is crucial in making informed investment decisions. In this article, we will explore the relationship between preferred stocks and rising interest rates, and clarify some common misconceptions.
The Impact of Rising Interest Rates on Preferred Stocks
It is a well-documented phenomenon that as interest rates rise, the price of preferred stocks tends to decline. This behavior is not dissimilar to that of bonds, another fixed-income investment. When interest rates increase, newly issued preferred stocks, along with other fixed-income securities, will typically command higher yields to be attractive to investors. As a result, the existing preferred stocks, offering lower yields, may become less desirable, leading to a drop in their market prices. This dynamic is particularly evident in periods of economic uncertainty, such as those characterized by rising rates, as was observed in the summer/fall of 2018. During that period, discussions about an inverted yield curve added to the general unease in the market, pushing down the prices of preferred stocks.
Exceptions to the Rule
However, it is worth noting that there are exceptions to this general rule. For instance, preferred stocks that are callable and issued by entities with a history of calling their issues at a price close to par (typically near $25) may exhibit less pronounced price declines. The concept of a callable preferred stock means that the issuer has the right to redeem the stock at a specified price, usually at par, before its maturity date. If the issuer chooses to exercise this right, it can effectively cap the maximum price that the preferred stock can reach. This is particularly relevant in interest rate environments where the issuer is incentivized to repay the preferred stock at a lower interest cost, thus reducing their interest expenses.
Price Behavior Beyond Par Value
It is important to consider how the price of preferred stocks behaves beyond their par value. When a preferred stock is selling for more than its par value, the risk of it being called diminishes, as the issuer would only benefit from calling the stock at par if the market price is still higher. As a result, in such scenarios, the decline in price may be less pronounced compared to other fixed-income securities. This phenomenon is partly due to the lower risk of liquidation, which can provide additional stability to the stock's price.
Conclusion
Understanding the relationship between preferred stocks and rising interest rates is crucial for any investor looking to navigate the complexities of the financial market. While preferred stocks typically exhibit a decline in price when interest rates rise, it is essential to consider the nuances of each issue. Callable features, the historical behavior of the issuer, and the price relative to par can all significantly impact the price movement of preferred stocks. It is always advisable to conduct thorough research and consult with financial advisors to make informed decisions in the ever-evolving landscape of investments.