Preferred Stock Investing: The Income Alternative You Haven’t Considered
by , Investment U Chief Investment Strategist
Friday, May 11, 2012: Issue #1771

The benefits of preferred shares is that you get a good yield, a more secure position than common stock holders and, in these uncertain times, less risk.

Perhaps the most pressing request I hear from investors these days is for an investment with a decent yield and not much risk.

Unfortunately, it doesn’t exist. High-yield stocks can tank. High-yield bonds carry default risk. Even conservative utility stocks can get socked in the stomach by higher inflation or interest rates.

There are, however, several solutions. You can own individual bonds so your expenses are lower and you’re assured of getting your principal back at maturity (provided, of course, you don’t plunk for the really junky stuff). You can diversify among high-yield stocks, accepting that you’re going to experience higher volatility than a bond portfolio.

But you should also consider something else: Preferred shares with their current 6% to 7% average yields.

Preferred shares are hybrid securities with the properties of both stocks and bonds. They generally carry no voting rights but have a dividend that has priority over the common stock. (Hence the “preferred” label.) And, like common stock dividends, preferred dividends are taxed at the favorable 15% maximum tax rate (although that may end come January 1 if President Obama and his fellow Democrats have their way).

The benefits of preferred shares is that you get a good yield, a more secure position than common stock holders and, in these uncertain times, less risk.

Of course, preferreds still fell in the recent financial crisis. But they dropped only two-thirds as much as the S&P 500. They also rebounded more strongly during the recovery.

For instance, the largest preferred stock ETF, the $8.5-billion S&P U.S. Preferred Stock Index (NYSE: PFF), returned 22% annualized over the three years through April, boosted by its high yield and heavy tilt toward the recovering financial services sector. That is more than two percentage points better than the S&P 500 over the period, and more than five points above the average high-yield bond fund, according to Morningstar.

But understand the downside, too. Like bonds, preferreds are interest-rate sensitive. When rates go up, prices go down. Unlike bonds, however, these securities will either never mature or may not for as many as 50 years. So if interest rates rise, the preferred investor could be stuck with lower-valued paper that a corporate issuer may never redeem.

At the same time, there’s limited upside potential with preferreds because the issuer typically has certain redemption rights. These generally include a “call” provision, where the issuer can buy out shareholders at face value after five years from the issue date.

There is also credit risk. Troubled companies can suspend preferred dividend payments. And while preferred stock is senior to common stock in a corporate bankruptcy, they’re subordinate to bonds in terms of rights to the assets of the company. (Preferred shareholders generally get nothing in a liquidation.)

Still, preferreds offer you higher-than-average yields, less volatility than common stocks and good diversification. In concert with a laddered bond portfolio and a high-quality stock portfolio, they make sense.

Preferreds aren’t a cure-all. Just an income alternative you may never have considered – and one component of a well-diversified portfolio.

Good Investing,

Alexander Green

Editor’s Note: In today’s edition of the Investment U Plus Alex recommends three simple options for investors looking to diversify with preferred shares.

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