Income Investing


A Preferred Yield Idea

Jeffrey R. Kosnett

Preferred stocks offer a safe, easy source of stable income.



Every so often I get an e-mail asking why Kiplinger's is thin with its coverage of preferred stocks. I don't have a perfect answer. My honest reply is there's been more oomph to real estate investment trusts and to newer income creations like the closed-end high-yield dividend fund and the emerging-markets bond fund.

Preferred stocks have a fixed dividend that can be fairly high, but the shares don't grow much in value. They are defensive income investments, whereas the alternatives get you good income but also better total returns when interest rates are low and the economy is growing. That's been the story for several years.

But now, with Treasury and corporate yields up (meaning the prices of these bonds are sliding) and yields on the emerging-markets funds and REITs fallen to where they are barely better than some CDs, you have more reason to seek out stable high yield instead of chasing yield-plus-growth. I know preferred stocks have a reputation something like tofu turkey. They don't appreciate like stocks, and they aren't as secure as bonds. But the income can still fill you up.

So I went to that splendid source of preferred-stock data and ideas, PreferredsOnline, and poked around. Turns out that a large number of preferreds are from banks. These are "trust preferred securities," a hybrid that trades like a stock but behaves like a five-year callable bond. Trust preferreds count as equity to bank regulators who monitor the financial institutions' capital base, but they are otherwise just like debt to the company, which doesn't dilute the interests of its common shareholders when it raises capital in this fashion.

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You can ignore that stuff, anyway, because it's for the accountants and the lawyers. For you, the appeal of trust preferreds is high income paid quarterly, with good security and little price fluctuation. Yes, your investment can be redeemed (called), but "if you're getting 7% and it's called in five years, you have a very good investment for five years," says Scott Merritt, a strategist for J.P. Morgan Asset Management. I agree.

Merritt, as well as many securities analysts, also says banks as a group are better off than it seems in a time of rising interest rates. That's because banks have more ways to make money than just by making a spread between the peanuts they pay on deposits and the higher rates on loans and mortgages. They aren't like the old savings and loans, which went under when they had to pay high rates for money while they collected low fixed rates on their loans.

So, then, what's available? Typical is a series of trust preferreds from U.S. Bancorp, the parent of U.S. Bank, which is big in the Midwest and the Pacific Northwest. It calls its trust preferreds ICONs, for "income capital obligation notes," but these things have all kinds of nicknames. Depending on the particular series of security, the U.S. Bank notes have a coupon yield of 5.75% to 7.35%. The newest ones, which are not callable until April 2011, have a coupon of 6.50%. To find the current price, go to Preferreds Online's price quote screen, type in USB (the symbol for U.S Bancorp) and you'll find the array of its trust preferred issues by maturity and yield. On Thursday, the 6.50s of 2011 (in theory, they mature in 2066, but that won't happen) traded at $24.50, so the actual yield to the call date is a little higher.

You can buy these securities through discount brokers. Fidelity even has its own generic name for the asset class: fixed rate capital securities. U.S. Bank's are rated A by Standard & Poor's and A1 by Moody's. According to PreferredsOnline, AAA-rated preferreds currently are priced to yield 6.3%, with yields rising steadily though the ratings until you hit 8% at single-B.

A 6% to 8% return isn't show-stopping stuff, but if you trust America's major banks to make good on their obligations, it's an awfully good source of nice yield ... easy and safe.

Opinions expressed in this column are those of the author.




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