You Might Prefer These Preferreds

A new breed comes with tax advantages

Preferred shares are a bit of a misnomer: Most investors would really rather own common stock. These securities, which pay a quarterly dividend, behave more like bonds. And the dividend income is taxed at the investor's ordinary tax rate, which can be as high as 39.6%. But a special breed of preferreds issued by closed-end funds might prompt investors to take another look.

What's different about these preferred shares--called Tax-Advantage Cumulative Preferred Stock--is that most of the dividends come from the issuer's long-term capital gains. This means the maximum tax an investor pays on these dividends is 20%--the top rate for long-term capital gains. "Here's something that's throwing off a lot of income with very little risk," says Robert Gordon, president of Twenty-First Securities, a New York brokerage. "If that isn't good enough, the yield is tax-favored."

So far, there are only five closed-end funds with these preferred shares. They're General American Investors, Gabelli Equity Trust, Gabelli Global Multimedia Trust, Royce Value Trust (which has two issues with two different dividend rates), and Tri-Continental. All of them trade on the New York Stock Exchange.

Consider General American Investors, a closed fund that's more than 70 years old. The fund is chock-full of capital gains that it has yet to cash in and distribute to investors. So two years ago, the fund sold $100 million in preferred shares, with a 7.2% dividend payout of $1.80 a share. The fund's managers used that money to buy more stock--in effect, leveraging the portfolio.

To make the preferred shares attractive, General American pays as much of the dividend as it can from the cash generated by taking long-term capital gains. Right now, that's about 84% of its payout. (With the other preferreds, the capital-gains portion of the dividend ranges from 65% to 93%.) The rest of the dividend is income taxed at the investor's ordinary rate.

General American first sold the preferreds at $25 a share, but interest rates have since gone up. So the market price for the shares is lower, at $23.63. That means the $1.80 dividend translates into a 7.62% yield. Fully taxed, that would amount to only 5.25% for an investor in the 31% federal tax bracket. Because most of the dividend is capital gains, the tax bite is lower, boosting the aftertax yield to 5.86%.

Or look at it this way: The investor would have to find a fully taxable 8.49% yield to beat the aftertax return on this preferred. Likewise, an investor in the 36% bracket would need at least a 9.15% taxable yield to beat General American's 7.62%. And for someone in the elite 39.6% bracket, the taxable yield to beat is 9.7%.

SOLID BACKING. Sure, you can find higher yields by taking on greater risk--like buying low-rated junk bonds. But with these tax-advantaged preferreds, you don't have to lower your standards. Of the six issues, five are rated Aaa by Moody's Investors Service. That's the ratings agency's highest grade, signifying that the issuers have more than adequate assets to back up shares. Tri-Continental's preferred shares are not rated, but it's hardly necessary: The fund now has $20 in assets for every $1 in preferred stock.

There are some caveats. If interest rates soar, all yield-oriented investments like these will go down in price. If rates plummet, they'll be called, and you'll have to sell them back to the issuer. A bad stock market environment could erode the issuer's assets, which in turn will endanger the credit rating. Even if the stock and bond markets keep humming, there's no guarantee that the issuers will be able to keep a high proportion of the dividend as capital gains distribution.

Still, the known benefits now outweigh the risks. Income-oriented investors might consider giving these shares preferential treatment.