Class of the Titans

Most investors are quite familiar with common stock and bonds, but preferred stock is another thing entirely. Could it be that among asset classes, preferred stock is actually the best investment out there -- or as I like to call it, the class of the titans? Let's take a closer look.

What it is
In many ways, preferred stock combines elements of bonds and common stock. It offers fixed payouts like a bond. But because it's so low in the capital structure, its risk characteristics look a lot like common stock. It's relatively illiquid, and if you're looking for capital appreciation, then traditional preferred shares -- as opposed to convertible preferred, which you can exchange for stock under certain conditions -- aren't the right place to seek out good investments.

That said, preferred stock typically offers higher yields than common stock. So if you're interested in more income and aren't worried about the company's financial prospects, then preferred stock might be for you.

In pursuit of yields
Right now, it's hard to find high-yielding investments. Savings accounts and T-bills pay virtually nothing. CDs pay a little more but not much, and even longer-term Treasuries aren't the payers they used to be.

On the other hand, preferred stock yields are quite a bit higher than common stock dividend yields for many companies. I looked at some NYSE-listed preferred stock issues from a variety of companies, including the following:

Sources: Yahoo! Finance, PreferredsOnline.com. Yields as of Feb. 2.

Those ranges give you a general sense of what yield you can expect. Clearly, you don't need the oracle of Delphi to tell you that preferred stock often has higher yields.

Should you buy it?
So if current income is what you're looking for, it may seem like a no-brainer to go right out and buy preferred stock. Moreover, income isn't the only benefit of owning preferred stock. Its returns also have low correlations with ordinary stock and bond returns, making them good diversifiers. A preferred stock will not rise and fall in lockstep with a comparable common stock, and it can also be less sensitive to fluctuating interest rates.

However, there's a downside to those traits. Price appreciation is all but nonexistent in the realm of traditional non-convertible preferred stock. And sometimes, even if the preferred stock does rise, most companies retain the right to redeem the issue at a preset price.

Furthermore, trading in preferred stock is fairly illiquid. And of course, there's always the risk that the company issuing the preferred stock may not be able to pay the dividends at all. That makes it essential to have confidence in a company's financial condition and its ability to keep paying dividends before you buy preferred stock.

Right for the time?
Will preferred stock beat out bonds and common stock going forward? Well, looking at some exchange-traded funds that track each type of investment, there have definitely been periods during which preferred stock came out on top. Take a look:

Source: Morningstar. Year-to-date (YTD) return as of Feb. 3.

As you can see, preferred stock didn't fare well in 2008, although it didn't lose as much as the S&P 500. But preferreds performed very strongly last year, due in no small part to the recovery in the financial industry, which constitutes a huge part of S&P's preferred stock index.

Right now, it seems that overall preferred stock returns are closely linked to the health of the financial sector. Therefore, if financials continue to outperform, a broad-based preferred stock ETF would probably do well. But with many financials already having posted huge gains, I'm dubious whether preferred stock can continue to post strong returns.

But that's just my opinion. What do you think? Leave me a comment below.