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The Short Answer

Preferred Stock May Not Be Your Best Choice

This asset class has its own share of drawbacks, and new federal regulations add uncertainty.

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Question: I notice that the yields on preferred stock are substantially higher than those that common stocks pay out, as well as most bonds. How do preferred shares of stock work, and what are the risks I should consider?

Answer: Preferred stock is a form of equity that carries many of the features of a bond, but with some key differences, which we'll get to in a moment. As you note in your question, the primary appeal of preferred stock for investors, especially those looking for alternatives to the low yields offered by many fixed-income vehicles these days, is that they tend to provide higher yields than bonds. In fact, the  iShares S&P U.S. Preferred Stock Index ETF (PFF) currently carries a yield of 5.89%. By comparison, the  Vanguard Total Bond Market ETF (BND), which tracks the entire U.S. investment-grade bond market, offers a yield of just 3.00%, and the S&P 500 currently has a dividend yield of about 2.25%. Preferreds' extra yield might sound like just what the doctor ordered for yield-starved investors, but naturally it comes at a price. Before we explore further, let's examine the pros and cons of preferred stock.

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