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By Jeremy Glaser | 04-14-2010 02:28 PM

Preferred Stock: The Worst of Two Worlds

Morningstar DividendInvestor editor Josh Peters thinks preferred stocks combine the worst elements of stocks and bonds.

Jeremy Glaser: Does it make sense to invest in preferred stock? I'm Jeremy Glaser for Morningstar.com.

I'm here today with Morningstar DividendInvestor Editor, Josh Peters, to see if there's room for preferred in investor's portfolios. Josh, thanks for joining me today.

Josh Peters: Happy to be here.

Glaser: A lot of investors, in this zero-yield environment, have been looking at preferred, having been asking us about preferred. So, first off, what are preferred stocks?

Peters: Well, preferred stocks are, in a lot of ways, kind of anachronistic. You look at capital structures of corporations going back into let's say the late 19th century, there was almost always a preferred stock.

A little layer there between the last of the bond holders and then the most junior claims on any kind of a corporation, which is its common stockholders.

What they are is, from the standpoint of a common equity holder, it's a fixed obligation, so it looks kind of like debt.

From the standpoint of a bondholder or a bank or some other kind of creditor, it looks like equity, since it's behind them in line to get paid.

So, in a lot of ways, these are securities that kind of combine the worst of both features [laughter] .

You don't have that protection of a contractual claim that you have with a bond, yet you don't have any opportunity to grow with traditional preferred stocks, any way to grow your income, the way that you would with common stock.

Glaser: Suffice it to say, it doesn't sound like you're a huge fan of preferred shares?

Peters: No, I try to look at them the same that Ben Graham did. He wrote that these securities were really inherently flawed, relative to both bonds or common stocks.

But if you could pick them up on a bargain basis, you weren't paying full price, you were paying a big discount - as I was able to do last summer with a couple of preferreds in our Dividend Harvest Portfolio - then they might be worth a shot.

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