The risk averse should look at preferred stocks offerings

Published: Monday, May 21, 2012 at 1:00 a.m.
Last Modified: Saturday, May 19, 2012 at 12:06 p.m.

So far in 2012, investors in both conservative and more speculative common stocks have been rewarded with solid gains, while investors in safe U.S. Treasury securities and bank CDs have seen disappointingly low returns. But for risk-averse investors who need income but who fear market volatility, none of these investments might meet their needs.

One possible solution is quality, investment-grade preferred stocks. Like any investment, however, it's critical that people investigate before they invest. One reason is that preferred stocks come in many varieties.

Preferred stocks are hybrid securities that have both stock-like and bond-like characteristics but that are normally closer to bonds than stocks in their risks and rewards. In the current low interest rate environment, however, their typical 6 to 7 percent dividends look attractive compared with that of bonds. Over the past three years, preferred stocks have generally outperformed both the S&P 500 and high-yield bonds.

Preferred stocks look like common stocks because they pay dividends as opposed to interest and provide the holder with company ownership and sometimes voting rights. But their dividends are not always "qualified" and thus are subject to the favorable 15 percent federal tax rate.

They look like bonds because, unlike common stocks, the dividends of most preferred stocks are fixed. Additionally, in the event of the company's bankruptcy, the preferred stockholder gets paid before the common stockholder and always receive their dividends before the common stockholder receives any.

Some preferred stocks are "convertible:" Under certain conditions, they can, at the stockholder's option, be exchanged for common stock. This is good because the preferred stockholder might benefit from a rise in the common stock's price.

Many preferred stocks are "callable:" The company can force the preferred stockholder to sell the stock after a specified date at a predetermined price. This is bad because, if interest rates fall, the value of the preferred will initially rise in a way similar to a bond but, as the call date approaches, the value will fall to the call price.

Some preferred stocks, instead of paying fixed dividends, adjust them periodically based on some index; for example, the annualized quarterly dividend rate might be set at 4 percent more than the 90-day U.S. Treasury bill rate. This is important in today's low inflation environment because inflation and interest rates will likely rise in a few years.

Preferred stocks have advantages and disadvantages over the common stock or bonds of the company. The key advantages:nThey pay high current income when compared with the common stock.nTheir dividend will be higher than the interest paid on the company's bonds.nThey have lower price volatility when compared to the common stock.

The key disadvantages are:nMost preferred stocks lack inflation protection in their dividend. Thus, their purchasing power will decline with time.nPreferred stocks generally lack capital gains potential. The combination of the call date and the fixed dividend provides little opportunity for long-term price appreciation.nUnlike bonds, some preferred stocks are "perpetual," that is, they have no maturity date when an investor knows that her investment will be returned. This is a problem because if the dividend rate is fixed and interest rates increase, the dividend will be worth less, the preferred stock's price will fall and the investor might never recoup her investment.

Like bonds, preferred stocks are rated by agencies like Standard & Poor's. The higher the rating, the less likely the preferred stock will have difficulty paying its dividend. In the current environment, I would bias but not limit a preferred stock portfolio to those that are investment grade and have adjustable rates.

Space does not allow me to highlight more than a few such stocks worth investors' due diligence. Following are symbols used on the website, which provides investors with ratings and other characteristics such as their dividend adjustment formula and taxability.

The symbols of suggested adjustable-rate, preferred stocks are PFK, HBA-D, PNC-L, MET-A, JPM-B, STD-B, AEB and GEP.



▲ Return to Top