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Preferreds: Part Bond-Part Stock

By Brian Kilb

Interest rates have plummeted to record lows, and many investors are frustrated that lower-risk assets owned for relative safety are paying next to nothing.  The 10-year U.S. Treasury note yields far below its long-term average of more than 6%.  And your cash account may not even pay you a cent in earnings.

If you have not explored preferred stocks in the past, you might consider them as a higher-yielding asset class offering less risk than common stock shares.

Preferred stocks are hard to define as an asset class because they belong somewhere between stocks and bonds. Technically, they are equities, but they share many characteristics with debt instruments and so are often called hybrid securities.

Companies issue preferred stock with a fixed face value or par value (often either $25 or $1,000) and pay dividends based on a percentage of that par at a fixed rate.  Just like bonds, the market value of preferred shares is sensitive to changes in interest rates. If interest rates rise, the share price or value of the preferred shares would need to fall to offer investors a better rate. If interest rates fall, investors want the preferred shares to rise in value.

Uncommon securities

Preferred shares differ from common stocks in that preferred shares will not appreciate (or depreciate) to the same degree as common shares relative to the company’s success or failure.  For that reason, investors looking for growth – and willing to take the risk – may be better off staying with common shares.

Preferred stocks pay dividends that are intended to last the life of the stock.  That does not mean that they have to be paid, however, as dividend payment requires board approval.  The dividends on preferred shares must be paid before the dividend on common shares – thus the preferred nature of this security.

Preferred shareholders also have a priority among creditors during liquidation of financially distressed corporations.  Bond holders are first in line, followed by preferred stockholders and then common stockholders, again placing the preferred security somewhere between a stock and a bond.

Also, if you’re interested in acting like an owner when you own stocks, preferred shares most often do not have voting rights.

Many institutions own preferred stocks for the preferential tax treatment they provide. IRS rules allow U.S. corporations that pay corporate income taxes to exclude 70% of the dividend income they receive from their securities.  This is known as the dividend received deduction, and it is the primary reason why investors in preferreds are primarily institutions.

Banks are the primary issuer of preferred stock.  Preferred stocks appeal to banks as they qualify as necessary Tier 1 capital, an important component in measuring a bank’s overall financial strength.

Do your homework

We’ll be waiting to see what, if any, impact the recently enacted financial reforms and pending income tax changes could have on both issuers and investors involved in a number of investments, including preferred stocks.

Meanwhile, as with any security, understanding the quality of the underlying institution is critical to owning a preferred stock. Proper research will determine whether the security is issued by a financially sound organization with potential to be a stable investment even in rocky economic circumstances.

Something else to make sure you properly understand when buying a preferred stock is whether the issue is callable.  Callable refers to a company’s rights to buy back the shares at a predetermined price often advantageous to the issuer.  Be careful you don’t get yourself into a situation where preferred stocks can be called at a disadvantage to you.

Check out preferred stocks as another potential asset class adding diversity, stability and higher dividends to your portfolio.  Part bond-part stock, you may have a place for these hybrid securities in your holdings.

Brian Kilb is executive vice president and chief operating officer at Landaas & Company.

initially posted October 15, 2010

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