Sometimes the best deals are found in the market's most obscure corners. If you're keen on high yields, for example, look at preferred stock, an offbeat type of equity that acts like a bond. Some pay dividends of 9%, compared with yields right now of 7% or so on bonds from comparable issuers. And the most alluring preferreds, yielding almost 10%, are even more obscure: They're shares issued in the U.S. by British and Spanish banks.
Why haven't you heard about these? The market for preferred shares is small, and their hybrid nature makes them tricky to understand. Only brokers who specialize in fixed-income investments are likely to be familiar with them. Big firms such as Merrill Lynch and Morgan Stanley Dean Witter let you trade online in many preferred issues, but online discounters are only starting to provide preferreds.
Preferred shares behave like bonds in several ways. Their prices rise when interest rates decline and fall when rates go up. Their yields are also relatively secure. They're called "preferred" because their dividends must be paid ahead of dividends on common stock. But if a company gets into trouble, it'll skip its preferred dividend before it defaults on its debt.
Preferreds can run for decades; they don't mature the way bonds do. So you can look forward to reliable income for many years--unless the issuer calls the shares. Be sure to learn each issue's call date, after which the issuer can buy back the stock at a specified price, typically $25 a share. Issuers usually don't call shares unless interest rates fall. But to be safe, try to buy shares below the call price. You don't want to buy at, say, $28--and be forced to sell the shares back to the company two years later at $25.
EXOTIC. Most preferred issues are offered at $25 a share for retail investors. Of the $160 billion outstanding, 70% comes from U.S. financial institutions and utilities. U.S. industrial companies account for an additional 13%. But the most interesting segment, 17% of the market, is issues from foreign companies. Many of these trade on the New York Stock Exchange as American depositary shares (ADSs). The shares are denominated in dollars and pay dividends in dollars. Because all of the shares trade in the U.S.--and none in the companies' home markets--you're not exposed to currency risk.
The fattest dividends come from big foreign banks that are ranked BBB+ or higher by Standard & Poor's and Moody's Investors Service (table). Merrill Lynch analyst Nick Roccanova suggests checking out issues from Royal Bank of Scotland, HSBC, and a couple of big Spanish banks, Banco Bilbao Vizcaya Argentaria (BBVA) and Banco Santander Central Hispano (BSCH).
Most of preferred stocks' risks are similar to those for bonds. An issuer's credit quality might slip or a crunch in market liquidity might hit prices. But before you buy, be sure you understand a quirky factor: foreign withholding taxes. Britain, for instance, withholds 10% on dividends. If your dividends come to $100, you'll get only $90. But under a treaty that keeps you from being taxed twice, you get a tax credit that lets you deduct the $10 from U.S. income taxes.
Trading in preferreds isn't as deep and liquid as in the stock or bond markets. So you've got to stay alert to pricing, which can sometimes get out of whack. But if you shine some light into the preferred market, you can find some remarkably juicy returns.