Savings Game

Preferred stock: Does it belong in your investment portfolio?

Updated: 2013-03-21T22:35:06Z

By ELLIOT RAPHAELSON

Tribune Media Services

Readers continue to ask how they can invest without a great deal of risk and still obtain reasonable income.

I have often pointed out that investors who need income cannot expect high income from investing in Treasury bills, money-market instruments and short-term savings accounts. Such investments preserve capital but do not keep up with inflation. Alternatives that provide more income include real-estate investment trusts (REITs), Treasury inflation-protected securities (TIPS), intermediate-term bonds, master limited partnerships (MLPs) and high dividend common stocks. These provide more income than the most conservative investments, but they are certainly are not risk-free.

Another alternative is preferred stocks. These are more like bonds than a common stock. They are hybrid securities with characteristics of both bonds and equities. Preferred stocks pay a fixed interest generally at a higher rate than bonds issued by the same company. The current yield of preferred stocks is about 6 percent. Corporations issuing preferred stock cannot pay dividends on their common stock without paying the interest due on the preferred stock.

Preferred stock prices generally fluctuate based on their dividend yield, credit rating and maturity date (where applicable). Increased interest rates generally will depress the value of preferred stock, since investors could purchase new issues of preferred stock and bonds at higher interest rates. If a corporation’s financial condition or prospects deteriorate, the value of its outstanding securities will fall.

Corporations that issue preferred stock are those that require substantial capital. Most issuers are financial institutions, utilities and communications companies. Not all of these companies have stellar credit ratings. There is not a large supply of high-quality preferred. For that reason, in order to minimize risks, investors should consider ETFs rather than individual purchases.

An advantage of preferred stocks is that they have a low correlation to other fixed-price securities such as TIPS, REITs and MLPs. A major disadvantage, according to Josh Peters, equity strategist of Morningstar, is the risk of recall. Most issues may be recalled within five years. If interest rates go down, the issuer will likely recall the stock.

Another disadvantage is there is no guarantee you will receive the price you paid for the stock. With individual bond purchases, at maturity, you will receive the face value of the bond back. Corporate bonds have maturity dates; most preferred stocks do not.

Another disadvantage is the lack of an active market. When you do decide to sell, there may be a large gap between the bid and ask price for an individual security. That is another reason to buy preferred stocks in an ETF.

The price of preferred stock will generally not increase because the income of the corporation increased. That will benefit common stock holders. You do not purchase preferred stock in order to obtain capital growth.

Abby Woodham, an analyst at Morningstar, recommends ETF iShares S&P U.S. Preferred Stock Index (PFF), indicating it has the lowest expense ratio of the ETFs at 0.48 percent. Over the last five years, the fund returned an average of 5.5 percent. The return for the last year was 18.2 percent. The current yield is approximately 6 percent.

If you hold your account outside of a retirement account, you should consider the tax implications. For example, some preferred stock dividends are qualified, which means that they are taxed at no more than 20 percent. If the dividends are not qualified, the marginal tax rate can be as high as 39.6 percent. Woodham points out that the PowerShares Financial Preferred (PGF) ETF produces 100 percent qualified income. Its expense ratio is 0.66 percent, higher than iShares EFT; however, if you hold the shares in an non-retirement account, the PowerShares ETF may provide a higher return.

Too many investors still invest too much in money-market instruments and savings accounts. You have to accept some risk to get high income. I do not recommend that a significant portion of your fixed income portfolio should be in preferred stocks. However, if a significant part of your portfolio is currently earning less than 1 percent, consider adding a preferred stock ETF to your fixed-income portfolio. You should earn close to 6 percent without a great deal of risk.

Elliot Raphaelson welcomes your questions and comments at elliotraph@gmail.com

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