By Stephen Taub
ARA Content
What’s a conservative, yield-craving investor to do? Six-month Treasurys are yielding less than 2 percent while two-year CDs are only offering up about 4 percent.
One alternative: preferred stocks, which are currently yielding about 7.5 percent.
For many years, these somewhat illiquid securities have mostly appealed to corporations since they were entitled to a 70 percent tax deduction on the dividends they earned. In the past few years, however, there has been a growing number of new preferred issues geared toward the retail market. They are called hybrid preferreds.
Preferred stocks are a hybrid between bonds and stocks. They act like bonds because they offer a high yield, but they are junior to all other debt securities. However, they are like a stock because they pay a dividend, which is usually cumulative if the company skips a dividend payment. And when a company is liquidated, this dividend is paid out ahead of common stock dividends.
There are two types of preferreds. With traditional preferreds, the issuer receives no deduction for tax purposes for the dividend payments made to the preferred holders. But the dividends are 70 percent tax-free to corporate investors. This was designed to eliminate double taxation at the corporate level. Hybrid preferreds were created so that issuers can receive a deduction for the dividend payments, similar to the deduction they receive for interest payments on debt securities.
There is currently about $158 billion worth of this new kind of security, which is usually issued with a $25 par value and pays dividends quarterly. More than $80 billion is owned by the retail market, while corporations have snatched about $47 billion of the preferred. Most of the issues these days yield around 7.5 percent.
Many different types of companies have issued this paper, including banks, insurance companies, utilities and industrial companies, and it can be referred to by any number of acronyms - CORTs, PERQs, CABCOs, QUIPs and more. Some are convertible into common shares of the issuing company or another company (convertible preferreds).
Most of them have investment-grade credits, according to Robert Ettinger, head of the trading desk for Flaherty and Crumrine Inc., a Pasadena, Calif.-based money management firm that runs about $850 million, mostly in two closed-end preferred stock mutual funds - The Preferred Income Fund and Preferred Income Opportunity Fund. The Preferred Income fund’s top five holdings (as of Aug. 31, 2001, the most recent period that it has filed these holdings) are in JP Morgan Chase, Bear Stearns, Bank One, Citigroup and Lehman Brothers. Preferred Income Opportunity, which tries to over-weight with utilities, has among its 10 top holdings preferred stock from Niagara Mohawk Power, SLM Holding, Houston L&P and Alabama Power.
“Many investors see CDs and money markets yielding 2 percent and then see recognizable name companies yielding 7 percent,” notes Ettinger. But, be careful. “These are long duration assets similar to typical 30-year and 40-year bonds,” he warns. So, they are not a sure, 7 percent thing. They typically come with five years of call protection. So, the big risk is when rates fall, they are frequently called at par and investors must reinvest them at lower rates.
“If rates rise, you can’t sell them for what you paid for them,” adds Ettinger. “You must know what you are buying. And, if rates go up, there are better things to buy”.
Still, now’s a pretty good time to look at them, since many pros expect interest rates to stabilize for awhile. When analyzing preferreds, keep in mind that you are really doing credit analysis because you’re trying to assure that the company will make its timely, quarterly dividend payments. To help you understand the company you are investing in, preferred securities usually carry a credit rating to evaluate the strength of the dividend payments. “Unlike stocks, you won’t participate in the company’s earnings growth,” adds Ettinger. “They [the preferreds] will move up and down with the general movements of interest rates.”
If you want to diversify and choose to invest in one of the closed-end funds that specialize in preferred stocks, remember they are not money market funds. They pay a fixed dividend rate and the price can go up or down. They also either trade at a premium or discount to net asset value. Warns Ettinger, “You won’t get back your NAV.”
Information on these securities, until recently, has been hard to find: there has been no one central place in the newspaper or on the Internet to get a listing or prices for these securities. And most income-oriented fund managers confess they don’t invest in this stuff.
“The Wall Street Journal” has recently been posting daily prices of most commonly traded preferred stocks, and Bondsonline.com has recently opened a preferred and convertible preferred database, PreferredsOnline (www.epreferreds.com), that provides investors with detailed information on these securities, including current and past credit ratings from Moody’s and S & P, and yields calculated on a current basis (current yield) and yield to call.
Stephen Taub is contributing editor to BondsOnline.com. He has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.
