Markets

Juicy Yields From Quirky Stocks

Don't confuse preferreds with low-risk CDs. They're trickier and riskier.

By David Landis, Contributing Editor

From Kiplinger's Personal Finance magazine, November 2003

For many years preferred stocks were relegated to an investment netherworld. They look like stocks and act like bonds, but are neither fish nor fowl. Then the stock market went into its three-year tailspin, and bond yields fell to their lowest levels in 40 years. Now, income-starved investors see these quirky securities as gorillas, with yields in some cases approaching double-digit levels.

Mike Hickey is a big fan. "People are disgusted with the yields of money-market funds," says Hickey, a resident of the Boston suburbs who sets up benefit plans for self-employed individuals. He favors preferred stocks of banks and real estate investment trusts, some of which yield up to 10%. That's pretty snazzy compared with the 1.6% yield of Standard & Poor's 500-stock index and the average 5.9% yield of high-quality, long-term corporate bonds.

No free lunch

Recently, preferred stocks yielded an average of 7.1%, according to Preferred Stock Online. Such yields are generous for a reason. Preferreds are riskier than bonds, and their prices usually don't rise as fast as those of common stocks. "We often call preferred stocks the worst of both worlds," says Alan Skrainka, chief market strategist for broker Edward Jones, which advises clients to avoid them.

What's more, preferreds seem to come in as many flavors as Baskin-Robbins ice cream. Dividends from traditional preferred shares qualify for the new 15% tax rate. Hybrid preferreds, also known as trust preferreds, are more like bonds -- and their payouts are taxed at higher rates. Some preferred shares may be converted into shares of common stock or cash at the option of the investor; with others, the conversion is mandatory. Issuers may often call their preferreds -- that is, buy them back if interest rates are falling.

Researching preferred issues is no walk in the park. Few analysts cover them, and the media usually ignores them. Among free Web sites that offer help are Preferred Stock Online (www.preferredstockonline.com) and QuantumOnline (www.quantumonline.com). Both offer price quotes and links to background information.

It's just as tricky if you want to go the fund route. No regular mutual funds invest primarily in preferreds. You can buy closed-end funds that specialize in preferreds, but these funds come with their own complications (for more on closed-ends, see below).

So why bother with preferreds? Because in this low-interest-rate environment, every extra little bit of yield helps. Preferred stocks "are a very good way today to goose up your portfolio a little bit," says Susan Breakefield Fulton, a Bethesda, Md., financial planner.

For investors attracted by a steady income stream, preferreds are an accessible alternative to bonds. They typically carry a face value of $25, compared with $1,000 or more for corporate bonds. It's usually as easy to get price quotes for preferreds as it is for common stocks. Prices for corporate bonds are often hard to find. Corporate IOUs may trade infrequently, and dealer markups can be stiff. "I looked at bonds, but they were kind of awkward to invest in," says Mike Ganopoulos, 38, a Danbury, Conn., engineer who prefers preferreds.

Preferreds basics

Traditional preferred stocks pay a fixed dividend. Thus investors don't benefit from the growth of a company's profits, which may be used to boost dividends paid to common-stock holders and can be a factor in driving up the price of the common. In bad times, a company may suspend payment of a preferred dividend, but typically the missed dividends accumulate and are paid once regular dividend payments resume. (A company must eliminate common-stock dividends before it can tamper with preferred payouts.) If a company goes bankrupt or liquidates, preferred owners have a better claim on the firm's assets than common-stock holders, although both groups are way back in line behind bondholders.

Corporations pay dividends out of after-tax profits, making preferred stock an expensive form of borrowing. To get around that problem, financial engineers concocted a strain of preferreds that are created when companies issue bonds to specially created trusts, which repackage the bonds and sell them to the public as preferred stock. Payouts from hybrid preferreds are considered interest, not dividends. That allows companies to deduct the interest costs for tax purposes. But hybrid preferred dividends aren't eligible for the new 15% dividend tax rate and thus tend to offer slightly higher yields than traditional preferreds.

Hybrids have many bondlike features. They are usually callable after five years, which adds another layer of complexity to the purchase decision. For example, Wells Fargo Capital IV (symbol WSF), a preferred redeemable in 2031, offers an attractive 6.7% yield. But beginning in August 2006, Wells Fargo can call the shares for $25 each. With the preferred recently selling for $26, buyers need to factor in the potential loss of principal.

One crucial bondlike feature shared by both types of preferred issues is a tendency to drop in value as interest rates rise. That said, preferreds held up well during the recent run-up in bond yields. In July, when yields on ten-year Treasury bonds climbed nearly a whole percentage point, the Merrill Lynch Hybrid Preferred index lost about 3%. "That's actually pretty decent performance given what Treasuries did," says Eric Chadwick, vice-president at Flaherty & Crumrine, which manages several preferred-stock funds. Most preferred stocks are held by individual investors, who are less likely than professional investors to sell on short-term interest-rate swings, Chadwick says.

One antidote to rising rates is to buy preferreds that can be converted into common stock. "The best values in fixed income right now are in convertibles," says Richard Lehmann, president of Income Securities Advisors, a Florida investment firm. He likes a convertible issued by phone-service provider Alltel. At a recent price of $49, the preferred (AYZ) yields 7.9% (versus 3% for Alltel common shares). In May 2005 each preferred share will convert to 1.01 shares of Alltel common (AT). As long as Alltel's common stock, recently $47, holds steady, the preferred won't lose much value, no matter what happens to interest rates.

The option to convert, however, adds yet another moving part to an already complicated piece of machinery. And here's one more: Like bonds, preferred stocks are rated by credit agencies, such as Standard & Poor's (www.standardandpoors.com) and Moody's (www.moodys.com). A downgrade by one or more of the credit-rating agencies could send a preferred stock reeling. Be especially wary of "junk" preferreds, those rated below BBB- by S&P or Baa3 by Moody's.

The closed-end option

In the end, some investors may find closed-end funds that specialize in preferreds the easiest way to deal with all these nuances. But closed-end funds have their own peculiarities. Unlike regular mutual funds, closed-end funds issue a limited number of shares, which trade on an exchange. Depending on investor sentiment, their share prices can vary from the value of a fund's net asset value, or NAV. The shares often trade at discounts to their NAVs. But high-yielding securities are in such demand that, according to fund researcher Lipper, eight of the 24 preferred closed-ends recently traded at premiums to their NAVs. In general, you should avoid closed-ends selling above NAV.

Another factor adding risk to preferred funds is leverage. All try to juice their yields by using borrowed money to buy securities. This can magnify the impact of interest-rate swings on the fund's asset values. Between June 13 and September 2, during which Treasury-bond yields spiked 1.5 percentage points, share prices of preferred closed-end funds fell 5% on average.

Analyst Mariana Bush, of Wachovia Securities, advises investors to look for funds that hedge against rising interest rates. She likes F&C/Claymore Preferred Securities Income Fund (FFC; 866-233-4001), managed by Flaherty & Crumrine. The fund, which owns hybrid preferreds, recently traded at $25, a 1% discount to its NAV. Based on its current dividend distribution rate, it yields 8.3%.

--Reporter: Katy Marquardt

• Print
• Comments
• Email
• RSS