The Preferred Path to Getting High Income

The meltdown in the financial sector is creating opportunity in a corner of the market that is often ignored: preferred stocks. Recent issues of these hybrid securities, which look like stocks but have some bondlike qualities, are paying as much as four percentage points more than the yield of 30-year Treasury bonds. That's double the average spread over the past five years. Opportunities in preferreds, says Richard Lehmann, president of Income Securities Advisors, a Florida investment firm, are "better than in most stocks I'm looking at."

The catch is that the issuers of most of these high-yielding preferred stocks are big banks and brokers that have suffered devastating losses since the subprime-mortgage crisis began last year. By some estimates, they have been forced to reduce the stated value of bad loans and other questionable assets on their books by nearly $400 billion.

To continue lending, battered banks need to raise more capital, but they face a hostile market for their common stock. They have found plenty of takers, however, for preferred shares, thanks to generous dividends and a slightly higher safety level. If a company goes bankrupt, preferred shareholders get paid before common shareholders, although bondholders trump both groups.

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Financial-services companies could face more pain, but many experts say the juicy yields make the risks of investing in their preferred shares worthwhile -- especially if you stick with those issued by the biggest, most diversified banks and brokers. Financial institutions "should continue to experience earnings pressure," says Barry McAlinden, a preferred-securities analyst for UBS Wealth Management Research. "But over the longer term, we think things will turn out well."

One issue McAlinden likes is Bank of America's Series H preferred, which debuted in May at a price of $25 and carries a respectable A+ safety rating from Standard & Poor's. The shares pay a quarterly dividend of 51.25 cents per share. At a mid-August price of $25, they yielded 8.3%.

The scoop on preferreds. There are many varieties of preferred securities, each with a series of moving parts. The shares typically have a face value of $25 and tend to fluctuate only modestly. Like bond prices, preferred prices are sensitive to changes in long-term interest rates and perceptions about the health of the issuing company.

Virtually all of an investor's return comes from a fixed dividend that must be paid before common shareholders get any payout. In some cases, preferred dividends qualify for generous tax treatment -- the top federal tax rate on qualified dividends is 15% (at least until this special break expires in 2010). Other hybrids, known as trust preferred stocks, are structured so that the "dividends" are actually interest payments, which can be taxed by Uncle Sam at rates as high as 35%. It's best to hold these types of preferreds in tax-deferred retirement accounts. However, most recent preferred issues, including the one from BofA, pay dividends that qualify for the lower tax rate.

Traditionally, preferred dividends are cumulative. That is, if the dividend is ever suspended, the issuer must make good on all the missed preferred payments before resuming dividends for common shareholders. But many recent preferred issues, such as Bank of America's, are not cumulative.

Sometimes preferred shares can be converted into common shares, a perk that gives investors a chance to profit from a rising common stock price. For example, Archer Daniels Midland's A-rated preferred, issued in May 2008 at a price of $50, pays an annual dividend of $3.13 per share. At the preferred's mid-August price of $37, it sports a current yield of 8.5%. (The distributions are classified as interest payments, so they're not eligible for the 15% tax rate.) The shares must be converted to common stock by June 2011, a feature that will pay off if the agriculture processor's depressed common shares, recently at $26, rebound into the $50s by then.

Finally, preferred shares are almost always callable, usually beginning five years after they're issued. So if prevailing dividend-coupon rates and interest rates in general are lower when the call date rolls around, the issuer may insist on buying back outstanding shares at their face value. The BofA shares, for example, are callable in 2013.

You can purchase preferred stock through most full-service and discount brokerages, although finding information about them isn't always easy. A good place to shop for preferred shares is QuantumOnline, a free Web site that offers plenty of basic information.

Spreading your risk among a number of different issues is just as important for preferred shares as it is for common stock. Few traditional mutual funds specialize in preferreds, but three exchange-traded funds and many closed-end funds do.

Among ETFs, we like iShares S&P U.S. Preferred Stock Index (symbol PFF). Financial-sector stocks make up about 75% of the fund, reflecting the composition of the market, but its top two holdings are mining firm Freeport-McMoRan (9% of assets) and Ford Motor (7%). Year-to-date to August 11, the fund lost 5.5% (on a total-return basis). The fund, which recently yielded 7.6%, charges annual expenses of 0.48%.

Like ETFs, closed-end funds trade on exchanges, but they issue a limited number of shares and almost always trade at prices that vary from the value of the fund's underlying assets. Among the preferred-stock funds recommended by Thomas J. Herzfeld Advisors, a Miami firm that specializes in closed-ends, is John Hancock Patriot Premium Dividend Fund II (PDT). Year-to-date, the fund lost 9.8% on its assets, beating the S&P 500 by nearly a percentage point. Based on the fund's most recent monthly dividend of 5 cents per share and a recent share price of $9, Premium Dividend yields 6.6%. That may seem low, but about two-thirds of the fund's assets are invested in utilities, which are considered less risky than financial firms. Financial stocks account for about 20% of assets. The fund's shares trade at a 16.5% discount to the value of its assets, which is not unusual for a closed-end fund. Investors can profit if the discount narrows, or if the fund's payout or the value of its assets rises.