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My Preference for Preferred Stocks

Jeffrey R. Kosnett, Senior Editor, Kiplinger's Personal Finance
Preferred stocks are having a great year. Here are six investments to buy into the category.

Preferred stocks may sound like humdrum investments, but the category's performance has been anything but, with year-to-date total returns of about 7.5%. In March, 15 new offerings totaling nearly $3 billion appeared, four times the usual monthly quota. That's good news for anyone looking for fully liquid investments that pay a significant yield premium over Treasuries, bank deposits and most dividend-paying common stocks. Preferred shares pay a fixed dividend that takes priority over common-stock payouts. Common stockholders can't get a cent unless preferred investors are paid as promised, though bondholders get paid first.

See Also: 7 Best Ways to Earn More on Your Savings

Explanations for the burst of new preferreds include random timing; companies raising money for mergers and acquisitions; and issuers eager to pay off or refinance their bank and bond debt on easy terms. Businesses with good to middling credit ratings can lock up financing for 6% or so, possibly in perpetuity because a preferred stock normally lacks a specific maturity date, although the issuer can often redeem after five years. For savers, a coupon rate of roughly 6% is excellent now that interest rates aren't rising and may indeed recede. For a CEO whose alternatives include issuing junk bonds, selling assets (creating a tax liability) or taking on variable-rate bank loans, preferreds are an affordable financing solution.

In truth, preferred stocks have been a great deal for ages. It's astonishing that they aren't more widely promoted. Word is getting out, though: Exchange-traded fund iShares Preferred & Income Securities (symbol PFF, price $37, yield 5.3%) has amassed nearly $15 billion in assets, which is a lot relative to an asset class that claims just $250 billion. (Prices, yields and other data are through April 19 unless otherwise noted.)

Great returns every which way. Standard & Poor's tracks preferreds in many ways, measuring the category broadly as well as sliced into fixed-rate, floating-rate, low-volatility, real estate investment trust preferreds and more. The 10-year annualized returns through early April are grand: 10.5% for U.S. investment-grade preferreds, for example, 11.4% for REIT preferreds and 12.4% for preferreds whose initial fixed rates eventually convert to floating rates. The outsize gains of 2009 inflate 10-year records. But if you start at 2010, you still have excellent returns with little volatility and few defaults or skipped dividends.

Astute fund managers have added huge value. Flaherty & Crumrine, a manager of closed-end preferred funds, is tops. The F&C Preferred Income Fund (PFD, $14) has a nine-year average annual return of 10.7% and a 10-year annualized gain of 16.9%. Sibling funds F&C Preferred Securities Income (FFC, $19) and F&C Preferred Income Opportunity (PFO, $11) have similar returns. Circling back to the latest offerings, notable debuts include Digital Realty Trust's 5.85% Series K (DLR-K) and Brighthouse Financial's 6.60% Series A (BHFAP). (It can be tricky to find prices and symbols for preferreds, but brokers, Morningstar.com and the Wall Street Journal are reliable.)

Preferred shares are issued with a fixed face value and, in theory, can be redeemed at that value--typically $25 a share. I think it's okay to buy preferreds at prices up to $26 a share--about where the better new issues trade now--because a generous yield compensates for that possibility.

As for risks, the bears worry that short-term traders' antics could cause a mini panic, or that stellar gains and rising demand will foster a pile of junky offerings and a burst of defaults and downgrades. I never say never, but I've heard those warnings for years about REITs, utilities, high-yield bonds and municipals, too, without any cataclysms. There are many protections for preferred shareholders. Don't be too nervous to take advantage of a great opportunity.

See Also: 33 Ways to Get Higher Yields

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