High-Yield Stocks That Are Riskier Than You Think

From their name, preferred shares sound like a great way to invest in the stock market. But as many investors are finding out for the first time, just because you own preferred shares doesn't mean that your money's not at risk.

Until recently, you may never have even heard of preferred stock. Most companies have only a single class of common shares that trade on stock exchanges. Yet the recent government bailouts of Fannie Mae and Freddie Mac -- and the resulting decimation of the value of both common and preferred shares -- have brought preferreds back to the forefront.

What's preferred
For companies that use it, preferred stock plays an interesting role in the capital structure. It typically combines several features of debt and equity into a single security.

Preferred stock resembles debt in a number of ways:

• It almost always pays a dividend that preferred holders must receive before common shareholders get any dividends, and its yield is usually higher than the dividend yield on common shares.
• Some preferred shares have maturity dates on which the company pays a fixed amount to shareholders to redeem the stock.
• In the event of bankruptcy or liquidation, preferred shares have priority over common shares.
• Traditional preferred shares usually don't rise much even when a company's common shares go through the roof.

On the other hand, preferred stock also includes a number of characteristics of equity:

• Some preferred shares also have conversion rights, allowing shareholders to exchange their shares for common shares under certain circumstances.
• Bondholders have priority over preferred shares in the event of bankruptcy or liquidation.
• The company can suspend dividends to preferred shares.

It's those last two points that Fannie and Freddie preferred shareholders are finding out firsthand.

Who uses it
You'll often see companies in the financial industry use preferred stock as part of their capital structure. But as you can see below, preferred shares aren't just for financials. Here's just a sample:

Source: Marketwatch. Data as of Sept. 9.

As you can see, yields on these preferred shares tend to be much higher than for the common shares. In some cases, the yields are incredibly attractive.

Yet just as high dividend yields on common shares can be too good to be true, you shouldn't see a high-yielding preferred stock as a no-risk proposition. In fact, in one sense, preferred shares give investors the worst of both worlds: they have full downside risk in the event that a company goes under, but their upside is typically limited, with most of the reward for that risk going to common shareholders. That higher dividend is usually the only payoff preferred shareholders get to compensate them for their risk.

Don't get fooled
Typical preferred investors aren't looking for the high-risk, high-reward payoff that common stock offers. More often, buyers of preferred shares want a steady stream of income at yields that are more attractive than corporate bonds offer. And as long as companies are healthy, preferred shares can deliver on that wish.

Unfortunately, many companies in the financial industry aren't perfectly healthy right now, and demand for new capital is high. But before investing in a preferred stock, make sure you understand exactly what you're getting into. Specifically:

• Look at the issuer's credit rating to judge risk of default.
• Look at the prospectus to learn what rights preferred shares have. Keep in mind that different classes of preferred stock by the same issuer can have different rights.
• Evaluate company financials to judge if anything will be left for preferred shareholders in the event of bankruptcy.

And remember: if it looks too good to be true, it probably is. Chasing yield is a risky proposition.

For more on being smart about income investments, read about:

• Dividends for a down market.
• Three ways to find riches from dividend stocks.
• Our list of top-rated high-yield stocks.