Preferreds might look and trade like regular shares, but they’re really just another way for companies to borrow money–pretty much just like bonds. But unlike that of a bond, preferred stock principal doesn’t have to be paid back if the issuing company goes belly up. The reason: While preferred investors are ahead of their common stock peers, they’re way behind the straight debenture owners in a bankruptcy deal.

We’re not looking at imploding companies when buying preferreds. Instead, we’re looking at companies with a solid standing in their markets that also pay us enough to entice us away from their traditional bonds. We’re also looking for some upside in share price with improving underlying business conditions.

We’ve had a collection of preferreds inside the Taxable Portfolio for some time now, with steady results in line with the rest of our bonds’ and bond-hybrids’ performance. We’ve yet to face a single credit issue with any of our Portfolio holdings or other recommendations.

Yet, investing in preferreds isn’t without risk. When it comes down to deciding whether to invest or not we need to acknowledge that the primary risk of buying any preferred is the issuer’s credit quality.

A major recession or big gyrations in interest rates across the yield curve make operating a bank or financial institution that much more challenging. But given their conservative credentials, all our preferreds are positioned to hold up well. As long as the issuers are healthy, the preferreds will remain firm.

There are a few key aspects about preferreds, as well as corporate bonds, of which to be aware.

First, there’s the possibility of being called out. The key to avoiding a loss on a potential call is to be aware of the yield-to-call before you buy.

If no calculation is broadly available, add up the remaining dividends before the first available call date. Then subtract the difference between the preferred’s current price and its call price. If the preferred trades for less than the call price, you have no worries.

The yield-to-call is this figure annualized and then divided by the share price. In effect, it’s your annual return if the preferred is called at the first available date. We always assume the worst, and that’s how we analyze the yields of our recommended preferreds and how we quote the yields. So, if the call is coming and it’s priced below the current price, we look at how the cashflows would run assuming a call out.

If the call date is far in the future and the call price is above the current market price, we go with the maturity. If a preferred is a perpetual, our analysis and quote are based on current yield.

Second, preferreds generally pay qualified dividends, taxable at a maximum rate of 15 percent. That’s another added bonus compared to other tax-consequence generating assets (e.g., many of our bonds and bond funds) that have their dividends/coupons taxed at ordinary rates by the IRS.

Your broker may not have heard of these preferreds, and you’re not likely to find quotes for them in your local paper. Quotes are available on the Internet from such sources as Google Finance, our new favorite in online data services. In addition, Bloomberg’s Web site can offer you some help, as can a new, free quotation service from Quotrek.

To evaluate preferreds, simply keep tabs on the health of the underlying companies, the same thing we do with any of our bond issuers.

Here’s a rundown on our preferred preferreds.

AES Trust III 6.75 Percent Series C Preferred is first on the list. AES Corp, a power company, is a solid generator of cash flows, making for a perfect issuer of preferreds. The preferred shares are trading around 50, giving us a yield of just shy of 7 percent with the call set at 50. AES Trust III 6.75 Percent Series C Preferred is a buy up to 50.90.

CMS Energy 4.5 Percent Series B Preferred is in the same market segment as AES. The preferreds are trading at a hair above 86. The utility company is another good foundation for income generation, with a yield still running in the mid-5 percent range. CMS Energy 4.5 Percent Series B Preferred remains a buy up to 90.

Far from a call is Health Care REITs 7 5/8 Percent Series F Preferred, with a dividend rate of 7.625 percent. Even with the potential call in 2009, we’re still getting a big yield-to-call in the 7.4 percent-plus range. Health Care REITs 7 5/8 Percent Series F Preferred is a buy up to 27.50.

Mid-America Apartment Communities 8 Percent Series H Preferred continues to advance and is a better deal than the company’s underlying common shares. Priced to yield in the lower 8 percent range and even to the next call in August 2008 at near 8 percent, the real estate company’s preferreds are a good buy. Buy Mid-America Apartment Communiteis 8 Percent Series H Preferred up to 26.50.

Thornburg 8 Percent Series C Preferred completes our holdings of Thornburg Mortgage, of which we also hold its common stock and corporate bonds. With the shares trading at a slight premium to the 25 level, the yield is running around close to 8 percent. Buy Thornburg 8 Percent Series C Preferred as prime yield-generator up to 27.50.

Our last issues in the Taxable Portfolio is Virginia Power Capital A Preferred, part of the Dominion Resources empire. Trading like the Thornburg issues at a slight premium above the 25 level, the yield to the likely call is still reasonable in the near 5 percent range. Buy Virginia Power Capital A Preferred under to 25.50.

Preferred Fund

There are two ways to go on the preferred front. The first is via our collection of individual issuers. The second is via a fund, with the closed-end version being our favored means of investing in packaged preferred shares.

Funds ease access to the preferred market and provide the ability to lever up higher-yielding preferreds; if we’re selective on the closed-end front, we can find some smooth performance and consistent dividend flows.

Nuveen Quality Preferred Income Fund (NYSE: JTP) is a prime example.

The fund is run by one of the better bond management houses, which tends to operate more in the open-end fund market. On the closed-end side, this particular fund fits our criteria for a stable source of higher cash flows.

Trading pretty much right at the net asset value of the fund’s underlying securities, the dividend flows (paid monthly) currently provide a yield of just shy of 7.4 percent.

Returns have been consistent. The fund has returned around 12 percent-plus for the past year, outpacing the five-year annual average of around 6.5 percent.

The underlying assets are in our favored industries for preferreds, such as financials and bank companies, which combined make up nearly 45 percent of the overall mix. Add in some of the off-shoots of other financials and that overall composition rises to around 70 percent or so.

This should continue to provide the needed stability in cash flows as well as credit quality–minimizing much of the default risk and other underlying credit risks in the preferred market. For more on the fund, click here. We’re adding Nuveen Quality Preferred Income Fund to the Taxable Portfolio as a buy up to 15.