WSJ: When Preferred Securities Make Sense

Investors seeking income might want to take a peek at preferred-stock funds.
What is preferred stock? It is a hybrid security that is a cross between equity and debt. Like debt, it pays a fixed amount of interest, and holders get paid before any common-stock dividends are distributed. But like equity, it tends to have larger price swings to both the upside and the downside.Buyers may reap handsome yields of around 6% with advantageous tax treatment on distributions. Still, you need to understand the nuances of preferred stock to get the most from it.
These securities are often issued by highly indebted companies that need lots of capital to operate efficiently. Broadly speaking that's banks and other financial institutions, telecommunications companies and utilities.
Risks to Weigh
Because preferred stock is in many ways priced like bonds, rising interest rates pose a risk to those who invest in it. When interest rates jump, the value of preferred stock drops, just like it does with bonds.
With bonds, the further away the maturity date is, the bigger the interest-rate impact will be. Because preferred is often like bonds with no maturity, there can be an even bigger price risk when interest rates rise, says Guy LeBas, chief fixed-income strategist at Philadelphia-based investment bank Janney Montgomery Scott LLC. Still, he sees it as a good risk these days.
"You need to balance out the rising rates against the fact that the yield on preferred is so much higher than on other investments," he says.
Yields on preferred stock vary but are around 6% a year now, which should be plenty of cushion against loss of principal based on what most strategists predict for interest rates this year, says Mr. LeBas. He expects only a modest rise in long-term rates.
When you buy preferred stock, be careful how much exposure you are getting to a single industry, especially if you already own common stock or bonds of companies in that industry.
The three big preferred exchange-traded funds, for example, are dominated by financial firms. While many investors may want that kind of exposure, Mr. LeBas notes that the banking sector saw massive selling of its preferred stock, bonds and equities during the financial crisis in 2008.
Fund Choices
Fund investors seeking preferred exposure can choose either ETFs or actively managed mutual funds. On the ETF side, look at PowerShares Financial PreferredPowerShares Preferred and iShares S&P U.S. Preferred Stock Index . Morningstar analyst Abby Woodham likes the latter, saying its expense ratio, 0.48%, "is the lowest of its peers."
In the five years through February, the iShares ETF returned an average 5.5% a year versus 4.9% for the Standard & Poor's 500-stock index.
For mutual funds, look at Cohen & Steers Preferred Securities & Income or Principal Preferred Securities . Morningstar data suggest these funds hold a significant portion of bonds, as well as preferred stock, though both companies say many of their securities are miscategorized. Cohen & Steers says its fund is approximately 94% preferred securities, while Principal says every security in its fund has the attributes of a preferred stock.
Tax Treatment
Many, but not all, preferred shares produce qualified dividend income that is taxed at a preferential rate of up to 20% versus the ordinary-income rate of as much as 39.6%.
That's the good news.
The bad news is that not all preferred-stock "dividends" qualify. Some securities are so-called trust-preferred stock issued by banks. The banks get to deduct the "dividends" of their trust-preferred stock as interest expense (thus lowering the after-tax cost of borrowing) and get to count it as capital.
If you buy preferred stock that is in fact trust preferred then you'll pay the higher tax rate. You should call the fund company to find out what portion of the fund is in true preferred stock versus trust preferred.
However, under the Dodd-Frank Act, banks this year will need to start phasing out use of trust preferred as capital. By 2016, no trust preferred can be counted as capital. "As a result we believe such securities will no longer be issued," Principal Funds said in a 2012 research note.
Meanwhile, if you want a fund chock full of preferred stock that will give you qualified dividend income, look to the PowerShares Financial Preferred ETF, which produces 100% qualified income, says Ms. Woodham. "I just wish it was cheaper," she says, noting the expense ratio at 0.66% a year is higher than other funds. The dividends from the other two ETFs are only partly qualified, which is a function of the indexes they follow, Ms. Woodham says.
How much of your portfolio should be in preferred stock? Janney Montgomery Scott suggests 10% of whatever you would allocate to fixed income.
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