Neither bond nor equity but with elements of both, preferred stocks are Wall Street’s third way to wealth. And, as the road less traveled, the yields are often sweeter and the risks less severe.

Roger Conrad, Personal Finance

With both U.S. treasuries and investment-grade corporate bonds yielding the lowest rates in decades, income investors are desperate to find yield. Bonds are the safest choice because they represent a contractual guarantee of principal and interest. But today this safety comes with a hefty price tag – investors’ psyches have never recovered from the 2008 stock market crash and continue to shun equities and favor bonds.

This “flight to quality” has caused bond yields to plummet, making it impossible for new income investors to earn a decent yield. Although great news for corporations seeking to refinance, it is horrible news for individual investors. As Personal Finance associate editor Roger Conrad recently wrote to subscribers in an article entitled Bond Buyers Be Wary:

Unfortunately, many income investors are abandoning stocks for what could prove to be an even bigger bubble in bonds. Worse, they’re doing it for potential returns that rate among the most meager in history. This would be an absolutely horrible time to buy bonds. The converse of companies being able to sell their bonds cheaply is that investor yields are paltry.

Common stocks don’t yield much either. For example, the dividend yield of the S&P 500 is only 1.9%, near the lowest in history. What to do?

Preferred Stocks to the Rescue!

There is a third option: preferred stocks. As Roger Conrad pointed out in an article entitled “The Third Way of Income Investing:”

Preferred stocks typically pay a higher dividend than a company’s common stock or bonds. That’s mainly because, in the event of a bankruptcy, their owners are paid off before common shareholders but after all bondholders and other creditors. And unlike common stocks, dividends are usually fixed for the life of the security.

No company can pay a dime of common stock dividends before it makes good on what it owes to preferred shareholders. And most preferred shares are cumulative; if the dividend were interrupted for any reason, the company would have to make good on back payments.

Here’s a quick rundown on preferred stocks, which combine characteristics of common stocks and bonds.

• Like common stocks, preferreds are typically exchange-traded and represent a partial ownership stake in a company.
• Like bonds, preferreds usually have a fixed payment and carry no voting rights.
• Most preferreds issued today come public at $25 per share, but then trade above or below that price in the open market based on current interest rates.
• Prices tend to be more volatile than bonds but less than stocks.

Preferred Stock Benefits and Risks

The “preferred” part refers to them being higher in the pecking order than common stocks — when a company pays a dividend or divvies up its assets after a bankruptcy event, preferred stockholders get second dibs on the payout (after bondholders). Naysayers will argue that preferred stocks lack the capital appreciation potential of common stocks as well as the contractual income certainty of bonds. But if you fancy a steady 7% yield, preferred stocks could be right up your alley.

As with any investment, it’s important to understand the risks. With preferreds, the five biggest risks are:

(1) rising interest rates, which dampen all fixed-income valuations;

(2) not enough buyers or sellers (i.e., liquidity), which refers to the danger of not having enough market volume to trade at the price you’re expecting;

(3) overconcentration in the financial industry, since approximately 80% of all preferred stocks are issued by financial companies;

(4) overvaluation caused by corporate investors bidding up the price (preferred stock payments made to corporate investors get a 70% tax exemption, an exemption not available to individual investors); and

(5) the corporate issuer runs into financial trouble, taking all or part of your investment with it. For example, a preferred issue of Ford Motor (NYSE: F) stopped making payments for more than a year between April 2009 and July 2010.

During the 2008-2009 financial crisis, preferred stocks lost a whopping 63.6%, worse than junk bonds (-32.6%) and much worse than investment-grade corporate bonds (-7.3%):

Source: Bloomberg

Comparing Types of Preferred Stock

Not all preferred stocks are created equal. A few of the important types of preferreds and their differences are listed below:

Types of Preferred Stocks
Traditional: Once a preferred, always a preferred. Perpetual with no maturity. After-tax distribution qualifies as a dividend subject to 15% reduced tax rate.	vs.	Hybrid: Pays pre-tax debt interest, not dividends, so has a set maturity date (20 to 30 years) and distributions do not qualify for 15% tax treatment. Most preferred stock issued today is this type.
Callable: Can be repurchased from you should the company see fit, usually beginning five years after issue, and usually at the issue price. Falling interest rates increase risk that preferred will be called away.	vs.	Non-callable: Can’t be called away. Rare these days, unfortunately.
Cumulative: Any missed dividends must be repaid later if payments are resumed. However, investors are taxed on unpaid dividends when they were supposed to be paid.	vs.	Non-cumulative: Missed dividends are gone for good, but yield is higher to compensate for this risk.

A Real Example in Personal Finance

Peeking around Personal Finance, I found three preferred stocks recommended in the Income Portfolio. One of them is Michigan-based electric utility CMS Energy (NYSE: CMS) Series B cumulative preferred stock, which pays $4.50 yearly via quarterly installments. It’s a traditional preferred with no maturity date and came public in 1968. As such, it is one of the increasingly-rare preferreds that qualifies for the reduced 15% dividend tax rate.

At a recent price of $83.17, that puts its current yield at 5.41%, a little too low for Roger, who recommends buying it only up to a price of $82. CMS Series B preferreds trade on the NYSE, and are represented as either CMS-B or CMS-PB, depending on your broker.

Sounds confusing, but it’s not. Armed with the company’s symbol and the preferred series, you need only to figure out which connecting lingo your quote service uses. These CMS preferreds can be “called” — that is, the company can buy the shares back from you for $110 each, and have a BB credit rating (junk status).

How to Buy Preferreds

QuantumOnline is a must-visit resource for the do-it-yourself preferred stock investor. Poke around the site (free registration required) and be sure to read the prospectus of each preferred stock before investing. As Personal Finance’s Roger Conrad writes in “The Third Way of Income Investing:”

Preferred stocks are much more complex animals than common stocks, and the only place to really get all the information is in the securities’ prospectuses. All important information in a prospectus can usually be found near the front in a section titled “The Offering.” This summarizes what’s being offered, when dividends will be paid, the terms of any potential redemption or liquidation, where the securities stand with regard to their claim on assets, or “Rank,” what if any voting rights they confer, if there are any conversion possibilities and where they’ll be traded.

If, after you’ve done additional research, you decide to buy an individual preferred stock, almost all regular stockbrokers can handle the order, especially if they trade on a stock exchange. For other preferreds traded only through dealers and not listed on an exchange, you’ll need the CUSIP number. The CUSIP number of the CMS preferred recommended in Personal Finance is 210518304.

Preferred Stock ETFs

If you’d prefer the safer route of investing in preferred stocks via a fund, I’d look toward ETFs rather than closed-end funds (CEFs) because CEFs often trade at a premium to their net asset values (a bad thing for new investors). The three ETF choices I am aware of are iShares S&P U.S. Preferred Stock (NYSE: PFF), PowerShares Preferred (NYSE: PGX), and SPDR Wells Fargo Preferred (NYSE: PSK).

Preferred Stock Tips

If you plan to invest in individual preferred stock issues, keep in mind that most preferred stocks issued today are of the hybrid variety and taxed at ordinary income tax rates, so they are best placed in a retirement account. Also be sure to remember the advice of Personal Finance’s Roger Conrad when selecting preferred stocks:

My cardinal rule for buying any preferred stock is to always stick to companies whose common stock I would want to own. Healthy and growing companies are the best possible assurance that interest and dividends will continue to be paid come what may.