Preferreds: A Big Gamble

Common stock isn't the only asset class benefiting from the revival of investors' appetite for risk. Check out the rally in preferred stocks. From the stock market's bottom on March 9 through June 5, iShares Standard & Poor's U.S. Preferred Stock Index (symbol PFF), an exchange-traded fund, returned an astounding 122%. Another ETF, PowerShares Financial Preferred (PGF), did even better, catapulting 171%. The S&P 500-stock index gained only 39%.

More to the point, since the market's March turn, preferreds have trounced other high-yielding investments, such as junk bonds and real estate investment trusts. Yet despite the rebound, many triple-B-rated preferred stocks are still priced to yield about 10%. What in the name of AIG is going on?

The ABCs. Before addressing that question, a quick refresher: Preferreds are essentially unsecured debt obligations of their issuers, most of which happen to be banks and other financial companies. Preferreds pay fixed dividends, so they resemble bonds. But in the event of a bankruptcy, bondholders get paid first and are likely to emerge closer to whole. Plus, unlike holders of common stock, preferred investors don't benefit from a company's earnings growth or its ability to boost dividends.

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The big allure of preferred stocks is high yields. And payouts from some preferreds are considered qualified dividends, which are subject to a maximum federal income-tax rate of 15%. Moreover, after so many financial companies have slashed or eliminated dividends on their common shares, preferreds enable you to put some financials into an income portfolio.

But the preferred market is relatively small, not terribly liquid and subject to hedge-fund shenanigans. So picking individual preferreds is tricky business (thank goodness for those ETFs). And buyers of individual preferreds face unfamiliar nomenclature, such as trust, cumulative and perpetual preferreds.

Unbeknownst to many investors, issuers also find ways to sabotage them. Bank of America, Citigroup and SunTrust, among others, recently made tender offers to buy their preferred shares at prices higher than the market but less than the $25-a-share par value at which preferreds can usually be redeemed. For investors, the experience is like buying a shaky bond for 50 cents on the dollar, smiling as the government gives the bond its backing, but then wincing as the issuer offers you 75 cents just when you think you'll eventually get the full $1 back. (To make matters worse, the banks offered common stock in their tender offers, not even cash.)

It's stuff like that that has some veteran financial advisers concerned that individual investors may jump into preferreds because of their recent hot performance without fully understanding the risks. "Yes, you've doubled your money the past few months," says Mickey Cargile, head of WNB Private Client Services, in Midland, Tex. "But if you've held them for a while, you've still probably lost 40%." Marilyn Cohen, who manages bond accounts for Envision Capital Management, in Los Angeles, and writes a newsletter, is even harsher. She says that some hedge funds "made a boatload of money" by betting boldly during the dark winter that the government would save the banks. "But retail investors can still get slaughtered," she warns.

Jason Brady, who manages or co-manages four Thornburg bond and income funds, is another skeptic. He nibbles at preferreds from time to time but much prefers buying corporate bonds rated single-A and triple-B. Preferred stocks rewarded audacious gamblers who were willing to place their bets when fear was pervasive. That's as it should be. But, Brady says, fear has receded and greed is back. To bet on preferreds today makes you a "riverboat gambler," in Brady's view. It's best to play another game.