Scared of the stock market but unhappy with the yields from safe bonds? Many investors feel that way about at least a portion of their portfolios. There is an alternative, and it actually is quite exciting for those who venture into it. It carries much lower risk than the stock market, but substantially higher yields than most bonds. Yet you won’t hear much about this investment from even the most savvy investment pros.
I’m talking about preferred stock.
Corporations can issue two basic kinds of stock. Common stock is direct ownership in a business. Its price tends to rise and fall with the underlying health of the business. If a business goes bankrupt, common stock holders are last in line to get paid. Creditors and bond holders get paid first.
Preferred stock is between common stock and a bond. Preferred stock has a claim on the assets ahead of common stock and after bonds. It also pays a dividend, usually much higher than the common stock yield. Also, the dividend rate is stated and fixed, unlike common stock dividends. (Although preferreds with yields that fluctuate with market interest rates are becoming more common.) The preferred stock dividend gets paid before any common stock dividend. Preferred stock dividends can be “cumulative.” If a dividend payment is missed, common stock holders don’t get any dividends until preferred share holders get all their unpaid dividends.
Preferred share prices don’t fluctuate as much as common stock prices. The preferred shares are more likely to fluctuate with interest rates and bond prices than with quarterly earnings.
Preferred stock generally pays a higher yield than bonds. Also, a bond has a specific time when it will mature and be repaid by the company. Preferred stock can have an unlimited life. You get principal back by selling in the market for whatever another investor is willing to pay. But most preferred stock is callable. That means the company can buy back the shares for a fixed price after a stated date, which it will do if interest rates have declined.
As a general rule, the more financially secure the company, the lower the yield on its preferred stock. The higher risk the company, the higher the yield.
There are three basic ways to buy preferred stock.
A few traditional open-end mutual funds buy a lot of preferred stock. Vanguard Preferred Stock is the only fund specializing in this area. But it buys primarily shares that qualify corporations for a special deduction. These shares pay a lower yield than regular preferred and aren’t a big help to individual investors.
Some funds, such as Berwyn Income and Northeast Investors Trust, often take big positions in preferred shares. But preferreds usually are less than 50% of the funds and that portion regularly. While these are very good income funds, they are for someone who doesn’t mind having preferred stock mixed with high yield bonds, convertible bonds, and other income investments.
There are closed-end funds that concentrate in preferred shares. These funds trade on the stock exchanges just like corporate stock. That means their prices fluctuate with supply and demand for the shares. The shares could sell at a premium or discount to the value of the funds’ investments at any time.
Eleven closed-end funds invested primarily in preferred stocks are listed in Barron’s each week. That doesn’t mean they invest 100% in preferred stocks, but generally most of their portfolios are in preferreds.
Two closed-end funds to consider if you want to invest in preferreds are Preferred Income (ticker: PFD) and Preferred Income Opportunity (ticker: PFO). Preferred Income concentrates in the utility and banking industries, having at least 25% of the fund in those two industries combined. The fund also uses some complicated hedging strategies so yields won’t fall dramatically when market interest rates fall. The fund also uses some leverage to increase yields.
PFO keeps about 25% of the fund in the utility industry most of the time. It pays a lower yield than does PFD. PFO also uses the same hedging and leverage strategies as PFD.
Each of these funds usually trades at a discount between 5% and 10% of net asset value. Buy when the discount is closer to 10%. As this issue closed, the discount was about 9% on each fund. Each week Barron’s lists the premiums and discounts of the closed-end funds.
Other preferred stock closed-end funds are offered by Chartwell, Delaware Group, John Hancock, and Putnam.
The third option is a portfolio of individual preferred stocks. You’ll want a diversified portfolio and need to examine the quality of each issuing company. You almost can set the yield the portfolio will earn with your stock selections. (Most yields are 3% to 20%, with the bulk 7% to 9%.) Remember that the higher the yield, the less financially secure the issuing company.
A list of all traded preferred stocks is in Investor’s Business Daily each day on the second to last page of the second section. You also can read the Income Securities Investor from the Bond Investors Association (800-472-2680).
I recommend investing primarily in top credit rating (or investment grade) preferreds. That means a rating of at least Baa from Moody’s and BBB from Standard & Poor’s. Also, emphasize shares that cannot be called for at least three years. After investing, don’t worry about fluctuations in share prices. You should be investing in preferreds for the income stream.
Dividend payments generally are quarterly, though some make monthly payments. If you want monthly income, you can include the payment dates in your selection criteria and design a check-a-month portfolio.
Preferred stocks give liquidity the small investor cannot get from individual bonds. Because preferreds don’t trade as much as common stock, your broker is important. Stick with the larger brokers and pay a low commission (about 50 cents per share). If your portfolio isn’t big enough to get good terms, use a mutual fund. Remember, as an income investor expenses are critical to your return.
Preferred stock can be the answer for those who want better than the 4% to 6% yields of safe intermediate bonds but who don’t want the short-term risk of high yield and emerging market bond funds.