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What is Preferred Stock

Investing in Preferred Stock
What will an investor do with a low-interest rate and high stock market? Is there no less risky way to get higher yields? Well, investing in preferred stocks could be the right answer.
What Is a Preferred Stock?

Preferred stocks combine the features of both bonds and stocks. They pay dividends like bonds, and so they seem attractive to an investor seeking to make a profit. Preferred stocks also appreciate. If you need an investment that comprises of income and growth, preferred stocks might be the ideal choice for you. For a novice in investing, preferred stocks could be an ideal choice simply because preferred stocks are more stable than common stocks.

Interest Rate Risk
It is imperative to have a great understanding of the affiliation between interest rates and their value before we invest in preferred stocks.

Prices of preferred stock prices have a reverse link with the movement of interest rates. Meaning that with a reduction in interest rates, there is likely going to be an increase in the price of preferred stock. And with an increase in interest rates, the preferred stock price is likely to decline. Having a good grasp about this relationship is essential, but it doesn’t tell us all we need to know. We also need to know how much changes will happen to the price. Is there likely to be a significant change in price or is it more likely to be little and insignificant? This is where you need to understand the duration.

What Is Duration?
Duration takes into account the price sensitivity of preferred stock to changes in interest rates. Duration is usually measured in years. With a higher duration, you should expect more declines in the price of your preferred stock if interest rates increase. Typically, for every 1% rise in inflation, the price of the preferred stock would also decline by 1% for every year of duration. While for a 1% decline in interest rates, the preferred stock would also increase by 1%. If the duration of your preferred stock is 5 years and interest rates decline 1%, the expected value of your preferred stocks will increase by 5%.

Proceed With Caution
Preferred stock is an investment that could appreciate and provide income. However, before you make your final decision as regards to investment, consider the direction you believe interest rates might move and to what extent. You should also use a duration calculator to know how much price risk you might be taking.

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