Selecting the Highest-Quality Preferred Stocks

While there are only three types of preferred stocks -- traditional, trust, and third-party trust -- they have a variety of characteristics that set them apart (specified in the prospectus). These characteristics allow you to tailor your purchase candidates to those issues that best fit your resources, goals, and risk tolerance.

There are currently 946 preferred stocks trading on U.S. stock exchanges (prices from Sept. 18, 2013). The highest-quality preferred stocks trading on U.S. stock exchanges, as defined by my proprietary selection criteria, are offering a current annual yield of about 7%.

Watch what happens as three simple criteria are applied to today's offerings.

Three risk-lowering characteristics
1. Investment-grade rating:
An important characteristic of most preferred stocks is that they are usually rated by rating companies like Moody's and Standard and Poor's, which is not the case with common stocks. By limiting the choices to those preferred stocks with an investment-grade rating from Moody's, we cut the list by more than half, down to about 400 issues (you can use S&P ratings if you wish; the result will be about the same). With 400 investment-grade issues to pick from, most risk-averse investors would rather not fool around with "speculative-grade" alternatives or those that are entirely unrated.

For example, CenturyLink (NYSE: CTL  ) subsidiary Qwest's CTU shares have investment-grade ratings from both Moody's (Baa3) and S&P (BBB-). CTU offers a 7% annual dividend to its shareholders and is selling for $24.16, just below this security's $25 par value.

2. Cumulative dividends: With common stocks, if the company decides not to pay a dividend, you're out the money. But many preferred stocks have a "cumulative" dividend characteristic, meaning that if the issuing company misses a dividend payment to you, it still owes you the money downstream -- its obligation to pay you accumulates. Limiting your choices to preferred stocks with cumulative dividends eliminates another 100 lower-quality issues.

Vornado Realty (NYSE: VNO  ) , a retail real-estate investment trust, provides several examples of preferred stocks with cumulative dividends, such as its Series J with its 6.875% dividend rate. VNO-PJ is available for $24.77, providing a 6.94% annual yield to buyers.

These two criteria -- an investment-grade rating and cumulative dividends -- are pretty easy for most risk-averse investors to warm up to. We're down to about 300 remaining candidates.

3. Minimum dividend rate: Rates and prices move up and down, and in opposite directions, over time. Buyers add dividend-paying shares when rates are increasing and prices are relatively low (such as the period we appear to be transitioning into). Sellers sell those shares once rates head back down and prices, accordingly, head back up. Doing so can add a capital gain to the dividends you have been earning in the meantime. It is for this reason that preferred-stock investing is long-term income investing, taking advantage of the known inverse relationship between rates and prices over time.

Historically, the highest-quality preferred stocks carry annual coupon rates between 6% and 9% (although they fell to about 5.5% for a few months earlier this year), with a long-term average of 7%. A 6% preferred stock can become hard to sell once rates start rising again and higher-paying alternatives are introduced.

Because low-paying preferreds are more quickly affected than higher payers, preferred-stock investors can avoid this pitfall by simply sticking with high-quality preferreds that offer a fixed dividend rate that is at least 0.5% above the bottom of the rate barrel. If seeing a "paper loss" in your brokerage account bothers you, staying at least 0.5% off the bottom gives you time to sell as rates head up (otherwise, just wait until rates and prices change direction again, and the paper loss will become a paper gain).

By eliminating the low-payers (less than 6.5% in today's market), we are left with about 85 extremely high-quality preferred stocks to pick from, and we now have additional principal protection at the low end as rates rise and fall over time.

Don't overdo it
Aligning a few preferred-stock characteristics with your personal risk tolerance allows you to eliminate the emotion (i.e., fear or elation) from the decision-making process. For example, my selection criteria (the three here plus seven others published in my book Preferred Stock Investing) filtered out the 57 preferred stocks of the big banks that would be claimed by the crisis and let pass the 13 issues of the big banks that were saved by acquisition. In 70 out of 70 cases, the emotionless filter got it right.

Source: Preferred Stock Investing, Fifth Edition, page 115.

But be careful not to overdo it. Adding criteria to your filter reduces your investing risk, but at the same time it reduces the number of candidates available to pick from. A filter that eliminates all candidates is of little value.

At a time when the Federal Reserve's policies have decimated the returns from savings accounts, savvy preferred-stock investors continue to earn yields of about 7% from the highest-quality preferred stocks. By using the specific characteristics of these securities that are consistent with your personal goals, resources, and risk tolerance (e.g., investment-grade ratings, cumulative dividends, and a dividend rate that is at least 0.5% above the bottom), you can earn a respectable return at what many would agree is an acceptable risk. And there's nothing complicated about doing it.

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