When interest rates are at historically low levels, as they have been for some time now, it may seem pointless to try to get decent income from your investments. After all, bond yields are extremely low, with "AAA"-rated corporate bonds paying about 2.2% and 10-year Treasuries paying just 1.8%.
One of the least understood and least discussed types of investment is preferred stock. Using these unique investments, which are neither stock nor bond, it is possible to achieve excellent returns without taking on much risk.
What is a preferred stock?
A preferred stock is a similar type of investment to a bond, with a few key differences. One major difference is that preferred stocks trade on the stock exchanges and can be just as easy to buy as any other stock.
Another difference is that preferred stocks are (usually) much cheaper than bonds. Most preferred stocks have a par value of $25, which means that whenever they mature or are called back (repurchased) by the issuer, the stockholders get $25 per share, regardless of the market price of the shares.
Much like bonds, preferred stocks have a "coupon rate," which is the interest or dividend rate paid to shareholders based on the original $25 price. So a preferred stock with a coupon rate of 6% will pay $1.50 per share in dividends each year for as long as the preferred stock is in existence.
Most preferred stocks are issued by banks or other financial-sector companies, but there are a few exceptions to this.
Why do they pay more than bonds?
In a nutshell, preferred stocks rank lower than bonds in terms of seniority, which is why they tend to pay higher yields.
Let's say a company goes bankrupt or otherwise doesn't have enough money to pay all of the interest on its debts. In cases like this, bondholders get paid first, followed by preferred shareholders, and then common shareholders. So, if a company can't pay its bills, there is a higher risk to preferred shareholders than to bondholders.
For example, preferred stock issued by Wells Fargo (NYSE:WFC) currently yields roughly 5%-7% per year, while the company's bonds currently yield less than 4% in most cases. So, for taking on slightly higher risk, you get a little more income.
Things to consider when choosing a preferred stock
Because preferred stocks trade on the stock exchanges, their share prices changes constantly based on the prevailing interest rates, the strength of the underlying company, and the length of time until the next date the shares are "callable" by the issuer.
As an example, consider all of the $25 preferred stocks issued by Wells Fargo. I use Wells Fargo here because it's a particularly solid company, and I'll get into the importance of this in the next section.
|Symbol||Coupon Rate||Current Price||Current Yield||Callable On or After|
|WFC-J||8%||$29.23||6.83%||Dec. 15, 2017|
|WFC-N||5.2%||$24.06||5.43%||Sept. 15, 2017|
|WFC-O||5.125%||$23.82||5.43%||Dec. 15, 2017|
|WFC-P||5.25%||$24.30||5.41%||June 15, 2018|
|WFC-Q||5.85%||$25.41||5.77%||Sept. 15, 2023|
|WFC-R||6.625%||$27.52||6.03%||March 15, 2024|
|WFC-T||6%||$25.37||5.94%||Sept. 15, 2019|
So you can obtain maximum yield by purchasing the J-series shares, which currently yield 6.83%. However, the shares are callable rather soon and are currently trading for $29.23, and you'll only get $25 per share if they are called. So, if Wells Fargo decides to call those shares on that date, you'll instantly lose more than 14% of your initial investment.
On the other hand, the Q-series shares pay a slightly lower yield of 5.77% but can't be called until 2023. So, if you buy these shares, you know your income is safe until then. Plus, they are trading much closer to the $25 par value.
Since most banks have several series of preferred stocks outstanding, investors can balance their income needs with the security of an income stream that will remain steady for years to come.
Not without risks
Because referred shareholders are lower on the totem pole than bondholders, it's especially important to buy preferred shares in solid, well-run companies.
This is why I use Wells Fargo for my examples here. Other solid preferred-stock issuers include U.S. Bancorp (NYSE:USB) and Goldman Sachs (NYSE:GS), to name just a couple. In my opinion, investors who buy preferred shares in these companies shouldn't have anything to worry about unless something drastically changes in the banking sector.
The bottom line is that even though preferred stocks are inherently more risky than bonds, so long as you buy those issued by rock-solid companies, you should have a reliable source of high income for years to come.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs and Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.