Investing in Preferred Stocks Part 2

In a previous article, I described the basic structure of preferred stocks. I concluded, “for high yields, steady income, flexibility and tax efficiency, preferred stocks can be a winning solution for many investors.”

I mentioned that preferred stocks often generate more cash flow, in the form of dividends, than the interest on bonds or the dividends on the common stock of the same issuing company. This can make them attractive to investors looking for current spendable income.

The fact that preferred stocks can be bought in small quantities, often at about $25 a share, makes it easy and inexpensive to diversify a preferred stock portfolio, compared to a bond portfolio. Taxation is another bonus, as preferred stocks often generate “qualified” dividends which are taxed at rates similar to capital gains (15-20%) instead of at ordinary income rates as bond interest is (up to 35% or more).

If this sounds interesting, you might want to look further into investing in preferred stocks. If so, there are a few things to consider.

Where to find preferred stock candidates

There are a number of websites that are devoted to preferred stocks. They offer screeners and other tools to point you in the right direction. One good example is preferredstockchannel.com.

Risks of Preferred Stocks

Preferred stocks come with their own set of risks. Here are some of the main ones:

• Risk of Nonpayment of Dividends – Since they are not a debt interest but are instead an ownership interest, the issuing company can suspend payment of the preferred dividends if cash is not available to pay them. Usually they must catch up on any late preferred dividends before making any payments to common shareholders. Such preferred shares are referred to as “cumulative”. If that is not the case, the shares will usually have “non-cumulative” in the name. These should generally be avoided. It is wise to check on the dividend history of any preferred stock you are considering. Dividend history is available from preferredstockchannel.com or from Nasdaq.com. A long unbroken dividend record is a good sign, though not a conclusive one, that the company is likely to continue paying their dividends.

• Credit Risk – Preferred shareholders are relying on the ability of the issuing company to continue to stay in business and meet its obligations. It is a good idea to check out the credit rating of any company whose preferred stock you are considering. You can register at the sites of Fitchratings.com or moodys.com for free, and look up the credit rating of any company whose preferreds you are considering by entering its ticker symbol into their search engine. The highest ratings are AAA, then AA, A, BBB, BB, etc. BBB is the lowest credit rating which is considered “investment grade”.  Ratings of A or better indicate low risk of failure to pay dividends.

• Interest Rate Risk –-. Preferred stocks pay a fixed amount in dividends per year. The shares will be designated with a name like “5.375% Series E Preference Shares”. That 5.375% in the name means that the shares pay a dividend of $5.375 per hundred dollars of face value every year. This amount will not change as long as the preferred shares are outstanding. In other words, preferred stock dividends do not increase, as dividends on common stock can. If the interest rate environment changes, that fixed dividend amount will become less attractive relative to other investment alternatives. In that case the market value of the preferred shares will drop. This is a concern if you need to sell the preferred shares. If you plan to hold them indefinitely, it will have little effect on you.

• Call Risk – Some preferreds are callable after a certain future date. This means that the issuing company can redeem them by paying the face value of the shares. This will usually happen only in a falling rate environment where the company can issue new debt or preferred shares with lower rates than the existing ones. Many preferreds continue to exist and pay their dividends long after the call date.

• Event Risk – This is a catch-all term for the risk that something bad could happen to any company. By definition, these events are unforeseen so it is hard to plan for them. One sign that a company is more vulnerable than usual to something happening that you don’t know about, is that their yields are much higher than that of their peers. This means that even though you can’t see a problem, someone else knows something. If an A-rated company’s preferred shares are paying a 13% dividend in a 6% world, it is a pretty sure sign of trouble ahead. In preferred yields, as in anything else in life, if it seems too good to be true it probably is. The best policy is to avoid the highest-yielding choices in each category, especially if those yields are way out of line.

By doing your due diligence as outlined above, and spreading your investment in preferred stocks among several different companies, you can build a solid portfolio of income-generating assets for your “steady income” allocation.

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