Are Preferred Shares Right for You?

Investors are often too narrowly focused on stocks and bonds, and thus the quiet hybrid that sits between these two assets is often neglected: preferred shares. The most basic definition of a preferred share is an issue of stock that's separate from the common offering and pays a fixed dividend that takes priority (hence "preferred") over the dividends of the company's common stock.

If the issuing company were to declare bankruptcy and the stakeholders were all standing in line waiting to get what little cash was left to distribute, the bondholders would be the first ones served, followed by the preferred shareholders. The poor common shareholders would come last.

As 11,000 baby boomers retire every day, there are more and more folks looking for income-producing securities to fund their golden years. In certain circumstances, preferred stock may be the answer to their needs. And I say "in certain circumstances" because there are some caveats.

For decades, retirees have looked to bonds to provide them with steady income and a guaranteed return on principle. Preferred stocks will also provide income, though without the guarantee of principle at maturity (with a few exceptions). But because additional risk doesn't usually come without some additional reward, the yields on preferred issues are often quite a bit higher than the coupons on bonds.

My client, Freddy, came to me after an ugly real-estate deal and was looking for some simple investments with a decent yield. At 80, he was concerned not with growth, but rather income. One of the investments I picked for Freddy was Bank of America Preferred 7.25% Series L Preferred Stock (NYSE: BAC-L) shares, which had just come out and were available at par. That meant Freddy could buy shares at $25 each with a coupon of 7.25%.

We had no expectation that the share price would increase, but it has appreciated about $1 since he bought his original shares. It could also have gone the other way and dropped, but the main reason to make a preferred purchase is the income. Bank of America's pay a current dividend of 1.11% (as of Nov. 6). Common shares are usually bought with the expectation of share-value appreciation, whereas the preferred are predominantly designed for income.

One other important consideration in your decision is taxation. Many common-share dividends are considered qualified dividends, which are ordinary dividends that meet specific IRS criteria that allow them to be taxed at the lower long-term capital-gains rate instead of the investor's ordinary income rate. Preferred dividends do not get this special treatment: They're taxed at the investor's ordinary income rate.

But don't run away just yet, because this may not be an issue for you, for a number of reasons. The most significant reason is that as of 2013, 43% of Americans paid no federal income tax at all, and a significant portion pay very little. For the lucky folks who fall into the higher tax brackets, preferred stocks make an excellent choice for investment in certain retirement accounts, namely Roth-type vehicles, where all money that's finally withdrawn further down the road is tax-free.

If you're looking for a steady stream of income and perhaps some capital appreciation on top, then don't make the mistake of overlooking preferred shares.