Preferreds not so stodgy

4/14/2008


Preferred stock is something of a misnomer. A preferred stock entitles the holder to a claim on company profits in the form of dividends. And those dividends must be paid to preferred shareholders before common shareholders.

But, in other ways, preferred stock is neither preferred nor stock. In a bankruptcy or liquidation, preferred shareholders stand only in front of holders of common stock in line at bankruptcy court. In other words, preferred shareholders are next to last in their claim on company assets.

Preferred stock behaves more like a bond than a common stock. Most preferreds pay a fixed dividend for the life of the stock. As a result, the price of a preferred share depends mostly on interest rates and the issuing company’s credit rating, rather than on company growth prospects.

So, in a way, preferreds are the worst of both worlds. They provide only limited long-term capital-gains potential, and few preferreds grow the dividend.

In addition, most preferred stocks are callable, which means the issuing company has the option to repurchase the shares for a prearranged price at a certain time. These call options typically benefit the issuer, not the investor.

Most, but not all, recently issued preferred stocks are callable five years after the date of issue. In addition, preferreds offer less security than bonds, since companies can only pay preferred dividends after satisfying obligations to bond holders.

Why bother with preferred stocks? Here are three reasons:

  • The biggest attraction of preferred stock is high yields. The S&P U.S. Preferred Stock Index yields 7.2%, versus 2.1% for the S&P 500 Index.
  • Because preferred stock prices don’t typically move in lockstep with either bonds or stocks, they can help diversify a portfolio.
  • Dividends of many traditional preferreds are taxed at a maximum 15% rate, the same as qualified dividends from common stocks, thanks to laws passed in 2003. Those laws could change, of course, and most of the preferreds issued recently are not eligible for the tax break.

Obviously, many investors like preferreds, as the size of the preferred-stock market has increased nearly four-fold since 1990.

Unlikely roller coaster
The last six months have been unusually turbulent for preferred stocks, generally considered conservative investments. The S&P Preferred Index fell 11.6% in the December quarter of 2007, while the S&P 500 fell 3.8% and the Lehman Brothers Aggregate Bond Index gained 3%. While the preferred index has recovered somewhat, rising 7.1% this year, it remains down 8.9% from year-ago levels.

Subprime mortgage troubles and other loan losses have contributed to the volatility, as financial companies issue most preferreds. Seeking safety, investors have fled from both equity and debt securities issued by financial companies. Even many high-quality preferreds have performed poorly.

Financial institutions in need of capital have flooded the market with new, high-yielding preferred stock in recent months. Those new issues have drawn investor attention away from older preferred stocks. In addition, hedge funds and other leveraged investors sold preferreds and other securities to cover mortgage-related losses, further pressuring prices.

Still, the preferred index may be able to build on its rise so far this year. The market has absorbed the flood of new issues, and the hedge funds’ panic selling seems to have abated.

Lower interest rates should also support the prices of preferred stock. Since last September, the Federal Reserve has lowered the federal funds rate to 2.25% from 5.25%, and further reductions are expected.

Recommendations
Higer-yielding preferreds may have their place in portfolios. If you’re shopping for preferreds, focus on investment-grade securities, or those rated at least BBB by Standard & Poor’s and Baa by Moody’s. But subscribers should not load up on just one or two stocks. Alternatively, preferred stock funds may be attractive to income investors looking for complete portfolios. Two funds are discussed below.

The iShares S&P U.S. Preferred Stock Index Fund ($44; ASE: PFF) exchange-traded fund seeks to track the S&P Preferred Stock Index. The fund holds 58 preferred stocks, with nearly 80% in financials. Yielding 7.2%, the fund has an annual expense ratio of 0.48%.

John Hancock Preferred Income ($20; NYSE: HPI), a closed-end fund yielding 9.3%, has 124 holdings. Nearly one-half of the stocks are in the financial sector, and the fund uses leverage to boast its yield. Over the last five years, the fund has returned 6.3% annually. Since inception in August 2002, the fund has delivered a positive return in every year except 2007 based on its net asset value. The expense ratio is 1.03%.


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