Learn About Preferreds Before You Buy

9/12/2011


The lofty yields of preferred stocks are no doubt enticing. At 7.0%, the yield on the S&P U.S. Preferred Stock Index easily outstrips that of other traditional income vehicles (see the table at right). But before you call your broker, we offer the following primer for new investors.

PREFERRED STOCKS OFFER TOP YIELDS
----------------- Index Total Return -----------------
Index Name
Est.
Yield
(%)
Year-
To-Date
(%)
2010
(%)
2009
(%)
2008
(%)
3-Year
Annual.
(%)
S&P U.S. Preferred Stock
7.0
0.3
15.0
45.0
(25.8)
10.0
Alerian Master Ltd.
Partnership
6.8
0.0
35.9
76.4
(36.9)
17.9
Dow Jones U.S. Real Estate
4.5
(0.4)
26.9
30.8
(40.1)
0.1
MSCI U.S. Investable
Mkt. Utilities
4.2
7.6
7.2
11.7
(28.0)
2.8
S&P 500
2.3
(6.1)
15.1
26.5
(37.0)
0.1

Preferred stocks are a cross between stocks and bonds. Similar to common stocks, preferreds represent partial ownership in a company — but generally without voting rights. Like bonds, most preferreds offer steady income in the form of fixed-rate dividends. In the event of bankruptcy, preferred-stock shareholders have a higher claim to a company's assets (and dividend payments) than owners of common stocks but rank lower than bondholders.

Preferred stocks can help diversify portfolios because of their low correlations with common stocks and bonds. Since 2003, the Wells Fargo Hybrid & Preferred Securities Index has had a 0.29 correlation with the Barclays Aggregate Bond Index and a 0.47 correlation with the S&P 500 Index. A correlation of 1.0 indicates that indexes move in lockstep.

Investors also gain tax advantages through preferred stocks. Similar to qualified dividends on common stocks, qualified preferred dividends are subject to the 15% rate for investors with a regular tax rate of 25% or higher. Among the 12 preferreds listed in the table below, seven are eligible for the 15% tax rate on dividends.

Preferred stocks also bear risks related to both stocks and bonds. Consider standard deviation, which measures how much monthly returns vary over time. The S&P U.S. Preferred Stock Index has a five-year standard deviation of 26.5%, versus 17.9% for the S&P 500 and 3.6% for the Aggregate Bond Index. Preferreds are generally less liquid than common stocks, which could potentially magnify trading costs.

Most preferred stocks are callable, allowing the issuer to redeem the shares at a specific date and price. And while most preferred stock dividends are fixed, companies can sometimes defer distributions — something they cannot do with bond payments. Preferreds are highly sensitive to deterioration in a company's creditworthiness. Thus, a downward revision of a credit rating will probably hurt the share price.

Preferreds are less likely than common stocks to be caught up in market sell-offs. The S&P Preferred Index is down only 5% from its May 19 high, substantially outperforming the S&P 500, which fell 13% in the same period. But a preferred stock's share price also tends to increase less than that of common stocks during stock-market rallies. Historically, dividend payments have accounted for nearly all the total return of preferred stocks.

SELECT PREFERRED SECURITIES
Preferred Stock (Price; Ticker)
Div.
($)
Yield
(%)
Call Date
Discount/
Premium
To Call
(%)
S&P
Credit
Rating
Eligible
For 15%
Tax Rate
Payment Dates
Aegon, 7.25% Perpetual
Capital ($24; AEF)
1.81
7.7
12/15/2012
(5.5)
BBB
Yes  
3/15, 6/15,
9/15 & 12/15
BB&T Capital Trust V, 8.95%
Trust A ($27; BBT-A)
2.24
8.4
9/15/2013
6.5
BBB
No
3/15, 6/15,
9/15 & 12/15
Deutsche Bank Cap. Trust X,
7.35% Noncumul. ($24; DCE)
1.84
7.6
12/15/2012
(3.0)
BBB
Yes  
3/15, 6/15,
9/15 & 12/15
Deutsche Bank Cap. Contingent Trust V,
8.05% ($26; DKT)
2.01
7.9
6/30/2018
2.4
BBB
Yes  
3/30, 6/30,
9/30 & 12/30
HSBC Holdings, 8.125% Subordinated
Sec. ($26; HCS)
2.03
7.7
4/15/2013
5.6
A-
Yes  
1/15, 4/15,
7/15 & 10/15
Kimco Realty, 7.75% Dep. Shares
Cumul. G ($26; KIM-G)
1.94
7.5
10/10/2012
4.0
BBB-
No
1/15, 4/15,
7/15 & 10/15
National City Capital Trust IV,
8.00% C ($26; NCC-C)
2.00
7.8
8/30/2012
3.2
BBB
No
3/15, 6/15,
9/15 & 12/15
Santander Finance, 10.5%
Noncumul. E ($27; STD-E)
2.63
9.7
9/29/2014
8.3
A-
Yes  
3/29, 6/29,
9/29 & 12/29
U.S. Bancorp, 7.875%
Noncumul. L ($28; USB-L)
1.97
7.1
4/15/2013
11.4
BBB+
Yes  
1/15, 4/15,
7/15 & 10/15
USB Capital XII, 6.30% K ($25; USB-K)
1.58
6.2
2/15/2012
1.9
BBB+
No
2/15, 5/15,
8/15 & 11/15
Wachovia Capital Trust X,
7.85% D ($25; WB-D)
1.96
7.8
12/15/2012
0.3
A-
No
3/15, 6/15,
9/15 & 12/15
Wells Fargo, 8.00% Noncumul.
Series J ($28; WFC-J)
2.00
7.1
12/15/2017
13.3
A-
Yes  
3/15, 6/15,
9/15 & 12/15

 


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