What--better returns with less investment risk?

March 8, 2002

With interest rates low, preferred stocks' yields may be particularly enticing now. Here's what you need to know about these investments.

 

What—better returns with less investment risk?

With interest rates low, preferred stocks' yields may be particularly enticing now. Here's what you need to know about these investments.

By Leslie Kane
Senior Editor

Bogged down with Treasuries that pay 3 percent interest? You can do better by shifting some of your stash into preferred stocks—a class of equities with bond-like features that can help reduce investment risk.

Preferreds trade on most major stock exchanges, but in several significant ways they're more like bonds than stocks. They don't give their holders voting rights. They pay shareholders dividends but at a fixed, specified rate, and they receive credit ratings based on the issuing companies' financial health. They get preference over regular stock when it comes to dividends and liquidation of assets. And when interest rates rise, preferred stocks' prices usually decline, like bond prices.

In 2000, $24 billion of preferred stock was issued; by Dec. 31, 2001, that total reached $59.7 billion. Why the big jump? The main reason is the public's growing awareness of hybrid preferreds, which offer some advantages over traditional ones. We'll tell you more about hybrids shortly, but first let's consider the pros and cons of preferreds in general.

A key benefit of preferred stocks is that their yields are often significantly higher than what companies pay on their bonds and common stock. Given the drop in interest rates over the past year or so, that's another reason preferreds have become so popular recently. For example, Royal Caribbean Cruises' preferred stock recently yielded 9.7 percent. In contrast, its zero coupon corporate bonds yielded 6.0 percent, and its common stock paid 3.0 percent in dividends.*

Another plus of preferreds: Because of their high income stream, you don't have to worry about company earnings or share price movement. "To make money in common stocks, the business has to prosper," says Jack Colombo, editor of Forbes/Lehmann Income Securities Investor, a Miami newsletter. "With preferreds, you can make good money if the company merely survives." (That's also the case with bonds, but keep in mind that preferreds' yields are higher.) "Preferreds give you an alternative to bonds—another way to cushion your portfolio," adds Colombo. "They're good choices for people who care more about income than appreciation."

As a holder of preferred stock, you're also usually more assured of getting dividends than someone who holds common stock. That's because most preferred stock is cumulative, meaning that if the company fails to pay scheduled dividends, they accumulate and must be paid before common stock dividends are doled out.

Still, those cumulative dividends have a flip side. "You'll be taxed in the year dividends accumulate, even though you haven't received them," says Greg Ghodsi, a financial adviser with Robert W. Baird & Co., an investment management company in Tampa, FL.

Potentially worse, not all preferreds are cumulative. About 25 percent aren't, and with these, you could simply forfeit dividends. Many noncumulative preferreds pay higher yields to help compensate for this risk, but not all of them do.

Whether cumulative or not, preferred stocks have other drawbacks. They're a bit riskier than bonds, because in the event of liquidation, bondholders get their principal back before holders of preferred stock do. Preferreds generally don't mature, either, so you can't be sure when—or if—you'll get all your principal back. And as with bonds, some preferreds are callable, meaning on a specified date the company can demand that you surrender your shares at the going price.

Moreover, trying to evaluate a preferred stock can be like reading Beowulf in Old English. "Common stock shares all have the same structure, but each preferred has its own peculiar definition," says Colombo. "Call dates, existence of a maturity date, and other factors vary. I saw a preferred stock prospectus that was 1,000 pages long."

The introduction of hybrids in the early '90s is partly responsible for the variety. Brokerages created hybrids to avoid tangles that prevented corporations from taking tax deductions for the dividend payments on regular preferreds.

Still, hybrids, which are a cross between traditional preferred stocks and bonds, offer individual investors some key benefits. Because brokerages issue them, it's easier for individuals to get information on them, comparison shop, and track their performance. Traditional preferreds, in contrast, are issued directly by companies and geared more toward the needs of institutions and mutual funds.

You can also invest less in hybrids. To buy some traditional preferreds you must invest a minimum of $100,000, but hybrid shares generally have a face value of $25. Commissions are comparable to what you'd pay on a common stock transaction. The most popular hybrids are MIPS, QUIPS, TOPrS, and CABCOs (see Common types of hybrid preferreds).

Overall, hybrids have made investing in preferreds simpler for individuals. Yet preferred stocks still make up one of the smallest segments of the fixed income market, notes Peter C. Stimes, an adviser with Flaherty & Crumrine, an investment management firm in Pasadena, CA. "That's because typically, casual investors don't have the time or resources to study and follow this market," he says.

But don't be quick to walk away from preferreds' higher yields. Keeping up to 25 percent of your portfolio's bond allocation in preferred stocks could add diversity and boost your overall return. To choose winners:

Study the prospectus carefully, or ask your accountant or financial adviser to evaluate the preferred stock. Make sure you know what you're buying, and that it's what you want. If you plan to buy several preferreds and follow the market, it may be worthwhile to get a subscription to Forbes/Lehmann Income Securities Investor newsletter (www.incomesecurities.com), which evaluates fixed income issues. The cost is $195 a year.

Stick with preferred stocks rated BBB or better. This minimizes your credit risk. Although even higher-rated preferreds could take a dive, starting with a better rating gives you an edge. Check a preferred stock's credit ratings through your broker or financial adviser; go to www.moodys.com or www.fitch.com , or call the company's investor relations department.

Avoid callable preferreds. Those that can be called within two years of purchase are particularly dicey—especially when interest rates are low, as they are now, because that's when calls are most likely to happen. However, after you've held a preferred for two years, you'll probably have collected enough in interest to offset any minor price decline plus transaction costs for selling. Check the prospectus to find out whether the stock is callable and, if it is, when.

Shop around. "Since preferred securities are a little riskier than bonds, hold out for a sufficiently higher yield or lower price to compensate for the higher risk," says Stimes. You can judge a preferred's yield and price by comparing them with those of comparably rated preferred stocks.

*As of Feb. 8, 2002.

Common types of hybrid preferreds

AcronymFull namePaymentsIssuer
MIPSMonthly Income Preferred SecuritiesMonthlyGoldman Sachs
QUIPSQuarterly Income Preferred SecuritiesQuarterlyGoldman Sachs
TOPrSTrust Originated Preferred SecuritiesQuarterlyMerrill Lynch
CABCOsCorporate Asset Backed Corp.SemiannuallyUBS PaineWebber

 

Leslie Kane. What--better returns with less investment risk?. Medical Economics 2002;5:31.