Preferred stock: It's an often-ignored, misunderstood investment, and because of that there's an opportunity for income-seeking types. These hybrid securities, which trade like stocks and pay income like bonds, offer higher yields than bonds of comparable credit qualities and have lower default rates. Better yet, many qualify for the 15% maximum tax on dividends, vs. the 35% maximum tax on corporate bonds.
In stormy markets preferreds can even be a safer harbor than bonds. "They are bought mainly by buy-and-hold investors, whereas institutions buy corporate bonds and trade them actively," says Richard Lehmann, publisher of newsletter Forbes/Lehmann Income Securities Investor. "So preferreds don't have the selling pressure bonds do when rates go up."
The big knock on preferreds is the scarcity of information on them. They are so far off Wall Street's beaten path that brokerage firms don't even use the same ticker symbols for them. Usually the initial letters are the same, but the suffix identifying it as a preferred changes.
More information and analysis is becoming available. QuantumOnline.com, a free site, makes it easy to screen preferreds by different characteristics, such as credit rating, coupon payment, or tax status. For $295 a year, PreferredsOnline, at epreferreds.com, has much the same information but with better screening tools and real-time prices. Lehmann's newsletter offers individual preferred picks and four model portfolios. The annual cost is $195.
Before you buy any preferred stock, check if the issue is "cumulative" or "noncumulative." Companies sometimes get into a cash crunch and omit dividends. With cumulative shares the company must make good on missed dividends. Noncumulative preferreds don't have that feature.
Although there are opportunities in U.S. preferreds, Lehmann is finding better plays in issues of foreign companies. The A-rated foreign preferred of the Royal Bank of Scotland, which at $25.99 yields 6.16%, is a "perpetual preferred," without a set maturity date. That means it has fixed cumulative dividends and a call date—when the company may ask to buy it back.
Opportunities also lie in third-party trust preferreds. Typically issued by large brokerages such as Merrill Lynch (MER) and Morgan Stanley (MS), these preferreds are actually corporate bonds the broker deposited in a trust. With names such as CorTs, CABCOS, SATURNS, and PPLUS, they are often hard to understand and consequently underpriced. One of Lehmann's favorites is Merrill Lynch's Depositor Preferred Plus Trust Series TWC-1, which holds bonds issued by media giant Time Warner. (TWX) It yields 6.06% at the current price of $24.75.
If individual issues seem daunting, consider an exchange-traded fund, such as PowerShares Financial Preferred Portfolio, or a closed-end fund, such as BlackRock Preferred Income Strategies Fund. Blackrock's yield is high because the shares trade at a discount to their net asset value, as closed-ends often do. The fund also uses leverage, which increases risk. Still, the extra yield could make it a smart bet.
By Lewis Braham