Get More Income By Investing in Preferred Stocks

With interest rates having been so low for so long, you might be wondering the same thing a number of clients have asked me: Where can I find additional income or dividends?

Preferred stock can be a great asset class to complement the right portfolio, but it can also be confusing to newcomers. These shares don't act quite like stocks or bonds, and have their own unique risks and benefits.

Here's what you need to know about them and how to incorporate preferred stock into your portfolio:

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(Before we get going, I have to remind you that every situation is different and that preferred stock isn't necessarily suited to every investor. If you're not sure about whether you should add preferreds to your portfolio, please feel free to reach out to me or seek out another experienced adviser.)

What They Are

Preferred stock occupies a special place in a company's capital structure, sitting in between debt and equity and offering some features of both. These shares are equities that can gain value if the company does well. Unfortunately, holders of preferred shares do not get voting rights, like they would owning other classes of equity.

The scheduled payments that preferred shares make to shareholders are also unique. Though they're usually structured as qualified dividends, the amount that preferreds pay is predetermined, unlike common stock dividends. This makes preferred stock look a lot like a bond, except that it's more common to receive dividend income than interest income on a preferred share. This can offer shareholders preferential tax treatment.

Who They're For

Preferreds are often appealing to income investors and are potentially more beneficial for those in higher tax brackets.

Because the majority of preferred dividends are "qualified," your preferred stock dividends will trigger a lower tax bill than you would pay on the same income from a taxable bond. Better tax treatment is especially attractive in a low-rate environment. (Again, every situation is unique, so please consult your accountant before making any tax-related decisions.)

Where They Fit in Your Portfolio

This special asset class does get higher priority than common stock, meaning that holders of preferred shares would get paid their dividends before holders of common shares. But preferred stock isn't as safe as your typical corporate bond—especially because some firms issue preferred stock precisely because they aren't able to get cheaper financing through bond issues. That means they are safer than common stock, but riskier than most bonds. It's important to do thorough diligence on any preferred stock to quantify and mitigate the risks.

Because they aren't perfectly correlated with either stocks or bonds, preferred shares can add a nice diversification benefit for your portfolio. But that doesn't mean you should go wild: In my experience, you want to limit your exposure to 5% to 10% of your portfolio value.

Also, keep in mind that financial companies are strongly represented in the asset class. In fact, about 80% of companies that issue preferred stock are financial institutions. It's a good idea to review your overall portfolio allocation to make sure that your preferred allocation doesn't produce too much exposure to the sector with respect to your risk profile and financial goals.

How They Help Prepare for Rising Rates

While it might sometimes seem like interest rates are never going to rise again, I think it's fair to say that nothing lasts forever in finance—not even low interest rates.

The good news is, historically speaking, preferred stock tends to do well when interest rates rise. Some even have floating-rate or adjustable coupon structures that keep payments in line with interest rates over time.

If the positive relationship between rising rates and preferreds holds in the future, shareholders could gain. Of course, it's impossible to know when rates might rise again or what the effects will be, so I caution my clients not to place big bets on it. Just keep it in mind as a potential long-term plus to holding preferred shares.

Why You Need a Professional

It can be tempting to research and buy preferred stock on your own, but because of the complexity and risk factors, I usually advise against it. Preferreds just aren't as easy to analyze as common stock—with their unique structure, as well as the influence that regulatory, credit and interest rate risks have on the asset class.

In fact, while I typically prefer Separately Managed Accounts (SMAs) for my clients, when it comes to preferred stock, I think mutual funds are usually the best choice. Typically, preferred stock is offered at either $25 par value or $1,000 par value. In my opinion it's important to have both in your portfolio to reduce volatility, potentially improve your overall performance, and increase diversification. Mutual funds have the liquidity and buying power to move large blocks of either one. On the other hand, with an SMA your manager might favor the retail-investor oriented $25 par value preferred stock. In that situation, you lose flexibility and could potentially hinder your performance. Going with a mutual fund gives you more access and a better chance at making the most of the strategy. I have a shortlist of mutual funds that I favor, and I'd advise you to also do your research when picking a mutual fund.

Overall, preferred stock can be a great addition to your portfolio, provided it suits your overall portfolio allocation, risk tolerance and time horizon. But there are so many factors involved that affect the value and stability of a given preferred stock, not to mention an entire portfolio. I definitely recommend speaking to an adviser to make sure your allocation is suitable for you and to help you find an appropriate professional to manage the strategy.

Bradford Pine is a wealth adviser and president of the Garden City, NY-based Bradford Pine Wealth Group. He assists individuals to create wealth, simplify their lives and plan for retirement.

Anna B. Wroblewska contributed to this article.