The Preferred Buy for Savvy Investors

Over the past year, bonds have captured the attention of investors looking for current income and greater safety than most stocks can provide. But if you're willing to look beyond bonds, you may find an investment with features that are far preferable to bonds.

Give yourself preferential treatment
When it comes to best-known investments, preferred stock doesn't make most investors' lists. Most investors own common stock and understand what it represents: ownership in the company. Preferred stock, however, doesn't fit neatly into the equity vs. debt framework, as it has certain characteristics of both bonds and common stock.

Preferred stock has many of the same traits that common stock has. When a company goes bankrupt, both preferred and common stock have to wait until all bondholders get repaid before they have any claim to the assets of the company. Both preferred and common shareholders are entitled to dividends when the company pays them.

But in many ways, preferred stock looks more like debt. Preferred shares have a preference over common shares in two important ways. First, if a company liquidates, any money left over after bondholders get paid goes to preferred shareholders first, and only then to common shareholders. Second, unless preferred shareholders receive the dividends they're entitled to, common shareholders can't get any dividend at all; but the reverse isn't necessarily true.

Perhaps most importantly, regular preferred stock doesn't have the unlimited upside that common shares do. Because companies typically retain the right to redeem preferred stock at a certain fixed price, there's a limit on the amount of capital appreciation that preferred shares will enjoy.

Get a better yield
So if preferred shares have the limited upside of bonds, but carry less protection from default, why buy them? The answer comes from the higher dividends you can get with preferred shares. For some issuers, the yield on their preferred stock far surpasses what common shareholders receive. Just take a look:

Sources: Quantum Online, Yahoo! Finance.

These companies illustrate a number of things about how preferred shares trade. With ConEd and DuPont, yields on the companies' common stock have grown so high that preferred yields needed to rise in order to compensate. In both cases, the preferred shares are trading well below their par value.

On the other hand, companies that are in weaker financial condition have some of the biggest differences in yield between their common and preferred shares. Alcoa, for instance, stands on the cusp of junk status, with one rating agency rating its preferred shares under the investment-grade threshold. Sallie Mae is also seen as a speculative issue. Even Goldman and JPMorgan Chase, though, sport attractive dividends on their preferred shares despite the fact that they've largely recovered from their woes during the 2008 financial crisis.

Should you buy preferreds?
One nice thing about preferred stocks is that many issues qualify for preferential tax treatment. While bond interest payments get taxed at your highest marginal rate -- up to 35% -- preferred stock dividends often qualify for the lower 15% tax rate. When you consider some of the high yields for these investments, you'll find that lower tax rates can make a big difference in your after-tax return.

The trade-off, though, is that you don't get the upside potential with regular preferred shares that you do with common stock. Unlike convertible securities, regular preferred stock doesn't offer an equity kicker that gives you exposure to a rising stock price. Instead, all you get is the higher yield. And if interest rates rise generally, you can expect preferred stock prices to fall.

You may also find that markets for preferred shares are fairly illiquid, with some stocks having little trading volume on any given day. The ETF iShares S&P Preferred Stock Index (NYSE: PFF) solves that problem by investing in a basket of nearly 100 preferred stocks. The ETF's current yield of 6.7% has made it attractive to yield-seeking investors.

In the final analysis, preferred stock has its place within your portfolio, but more as a way to supplement fixed-income exposure rather than as a growth vehicle like common stocks. If you stay aware of the risks, preferred shares can add diversification to bond holdings and enhance your yields.

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