Preferred stocks may not get as much press as their common brethren, but they have some advantages that regular equities don't.
Preferred shares are advantageous because they generally offer higher fixed-income payments than bonds or common stocks, the capital outlay to invest in preferred shares is lower than with bonds, and the prices are more stable than those of common stocks. What's more, many preferred shares are only taxed at a rate of 15%.
For a well-diversified portfolio, preferred shares should be a 5% to 10% part of the fixed-income allocation, depending on the market, says Jim Branscome, a managing director in the Standard & Poor's investment analysis group.
Many of the shares we are highlighting are cumulative preferreds, which means that a company that can't pay a dividend in one quarter will eventually pay it in another, once it has available assets. However, we also spotlight some non-cumulative shares. If dividend payments are missed on non-cumulative shares, they won't be paid later.
Branscome cautions investors against investing in preferred shares without some basic knowledge. First, he says, know the call date. Many preferred shares are callable, which means that the issuer has the option to buy back the shares on a certain date, at a price that could be less than the trade price on that date. Preferred stock listings with yields, ratings, and call terms can be found in the S&P Stock Guide. QuantumOnline (www.quantumonline.com), an aggregator of information on preferred stocks and other exchange-traded income investments, is another good source for call dates.
Second, Branscome warns investors to watch out for shares selling above par. Preferred shares are typically priced at $25 a share initially, though they can be priced higher or lower depending on the issuer. "If you see one selling at $26, you aren't going to get the stated yield," he says. "You need to make sure they're selling at or below par."
Also, call dates are tricky, Branscome notes. "If it is selling at $26 and the call date is 2008, you may end up with a problem. If it's called, it will be called at $25."
For investors buying preferred shares for a taxable account, Branscome advises buying those that are subject to the lower dividend tax rate of 15%. Fully taxable preferred shares are recommended for tax-exempt accounts, such as 401(k)s or IRAs. QuantumOnline lists those preferreds that are subject to the lower tax rate.
"The final thing to watch out for is that most preferreds are very thinly traded, and the spreads are usually wide," Branscome says. "If you put in a good-until-canceled bid for 1,000 shares, and the stock is only trading 5,000 shares a day, you are 20% of the volume. If you place a market order instead of a limit order, you are apt to pay a substantial markup."
When purchasing a preferred stock, look for issuers with high Quality Rankings and debt ratings, Branscome adds. As with a common stocks, these are indicators of a solid investment, he says.
Branscome's favorite preferred shares are those issued by closed-end mutual funds, which are usually subject to the 15% tax rate. The closed-ends issue the preferreds because it is one way they can raise capital to purchase additional common stocks, he notes. "Many of the closed-ends do have preferreds, and almost all of them pay out the coupon as capital gains," Branscome says. "In almost every case, they have a triple-A credit rating."
One example of such a preferred is General American's cumulative preferred stock, Series B, which Branscome owns in his own account. This was issued with a coupon of 5.95% in 2003 and is now yielding 6.4%. Taking into account the 15% tax rate, the effective yield is still above that of U.S. Treasuries, which are fully taxable at the federal level. This preferred was recently trading at $23.14 and is callable at $25 on Sept. 24, 2008. General American, founded in 1927, is one of the oldest U.S. funds.
We looked for companies whose common stocks are ranked four or five STARS, with Quality Rankings of A- or better and debt ratings of at least A-minus. We ran a screen that yielded 11 issuers. Of that group, we found that Bank of America (BAC), Citigroup (C), Lehman Brothers (LEH), Merrill Lynch (MER), and Pitney Bowes (PBI) had issued publicly traded preferred stocks. Pitney Bowes issued convertible preferred shares, which means that the purchaser has the option to convert the preferred shares into common shares after a certain date.
Whittling the list down further, we found 14 preferred stock issues from the companies listed above that qualified for the 15% tax rate. According to QuantumOnline, the tax-advantaged securities are ones issued by U.S. companies that paid income taxes on their earnings in the previous year.