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Millions of investors rely on their investment portfolios to generate much-needed cash. But lately, if you've been looking to get more income from your investments, you've had a dilemma to face: Should you accept the rock-bottom yields that ultra-safe income investments provide, or should you ramp up the risk level in your portfolio to buy dividend stocks, many of which pay much higher yields right now?
What many don't realize, however, is that there's another alternative to both of these choices. It's far from risk-free, but you'll be able to earn more income than you'll get on most regular dividend stocks -- and arguably with less risk.
Do you prefer door No. 3?
Just from the name, preferred stock sounds great. But most people don't understand what it is, let alone whether they should have it in their portfolios.
Preferred stock is a hybrid investment in that it looks partly like a bond and partly like a stock. On the stock side, preferred shareholders receive dividends rather than interest payments. Although investors in preferred stock usually get paid before common shareholders in a bankruptcy situation, they typically get nothing unless bondholders receive payment in full.
But like a bond, preferred stock usually pays a fixed dividend rate throughout its lifetime. Often, companies have set dates on which they redeem preferred shares, and the amount the company pays on that date is often fixed in advance. For regular preferred stock that doesn't have any conversion rights, that limits the potential upside to far less than what common shareholders can earn if the company is extremely successful.
The easy way to buy preferreds
One challenge to investing in preferred stock is finding it in the first place. Just knowing how to look up the current price on a preferred issue isn't always easy. Moreover, preferred shares usually trade far less frequently than their common counterparts, making markets illiquid and introducing a risk whenever you need to buy or sell shares.
To avoid these problems, many investors have gravitated toward preferred stock ETFs. The iShares S&P Preferred Stock ETF (NYSE: PFF ) has seen substantial interest from investors lately, having grown into an $8 billion giant. You can also find focused funds on certain areas of the preferred stock market, with the PowerShares Financial Preferred ETF (NYSE: PGF ) honing in on financial-sector companies that issue preferred stock.
Worth the risk?
The nice thing about these ETFs is that they offer high yields -- currently in the 6% to 7% range. That's not the highest yield you can find in the market, but it does compare favorably with the S&P 500's average yield of around 2%.
Yet the biggest danger of investing in preferred stock -- and especially in ETFs that own it -- is that so many of the issuers of preferreds are banks and other financial institutions. The PowerShares ETF is specifically designed to own financial-company preferreds, but even the iShares ETF has about three-quarters of its assets invested in bank and financial preferred stock.
Done the right way, though, preferred stock can be a smart play. Warren Buffett made nice returns from preferred stock investments in Goldman Sachs (NYSE: GS ) and General Electric (NYSE: GE ) during the financial crisis, and at least at the moment, his more recent deal with Bank of America (NYSE: BAC ) looks equally promising. But what made Buffett's deals so attractive was that he got an equity kicker -- in the form of warrants that let him participate in any upside for the common shares on top of getting those nice preferred-stock dividends. Even though Goldman and GE have already bought Buffett out, he'll still get the benefit of those warrants for years to come.
By contrast, you won't get the same terms Buffett did when you buy preferred stock. You'll bear the same downside risk and get a similarly attractive payout. But if B of A's turnaround continues, don't expect a huge reward -- that'll be saved for common shareholders.
Weigh the risk
If you plunge headlong into regular dividend stocks as an alternative to bonds, you take on substantial risk. Preferred stock eliminates some of those risks -- but not all of them. Before you jump onto the preferred-stock bandwagon, make sure you're comfortable with the financial-sector concentration that you may get -- and prepare for what could be a wilder ride than you'd like if the economic recovery takes a turn for the worse.
If you're looking for some other great dividend stocks, I suggest you check out "Secure Your Future With 11 Rock-Solid Dividend Stocks," a special report from The Motley Fool about some serious dividend dynamos. I invite you to grab a free copy to discover everything you need to know about these 11 generous dividend payers.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.