Preferred Stock May Not Be Your Best Choice

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.

The Pros
Yield, of course: As we've already mentioned, preferreds tend to offer higher yields than bonds. Unlike common stock, in which the dividend can vary based on company earnings, preferreds' dividends usually are fixed, meaning that investors have a good sense of what the yield will be.

Ahead of common stock in the pecking order: Preferred stock falls behind bonds and ahead of common stock in the capital structure, meaning that, while not considered a company obligation in the same sense that income payments to bondholders are, preferred share dividends take precedent over common share dividends when a company allocates its income. Preferred share dividends might be deferred, however, if the company runs into trouble.

Tax treatment: Dividends from most preferred stock is taxed at the 15% level, whereas income from bonds and bond funds is taxed at ordinary income tax rates.

So far so good, right? But as we'll see, preferreds carry their share of minuses, as well.

The Cons
Callable: Some preferreds have very long maturities of 20 years or more, while others have no maturity dates at all. Many also have provisions that allow the issuer tocall in the shares (typically five or more years after shares were issued and at par, or the issuing price). That means that if interest rates decline the issuer may decide to buy back the existing preferred shares in order to issue new ones at a lower rate. On the flip side, if rates go up, the holder of the preferred shares might be left holding a security that pays less than the market rate for many years or in perpetuity, effectively reducing the value of the holding.

No tangible benefit from company growth: Unlike common shares, which might appreciate as company earnings rise, preferred shares generally offer a fixed dividend, meaning that any company growth has minimal effect on the preferred share price. If the company goes into a tailspin, however, that preferred stock dividend could be threatened, hurting its share price.

Tend to be issued by heavily leveraged companies: Among the most common issuers of preferreds are financial-services, telecom, and utility companies, who use preferred stock as a tax-advantaged way to increase their borrowing power. Of course, this approach can lead to trouble for companies that borrow more than their balance sheets can handle, especially during economic downturns. Also, investors seeking to build a portfolio of preferreds to generate income are likely to encounter diversification problems because the market is dominated by preferred stocks from banks and other financial companies.

As you can see, the higher yield and tax advantages of preferreds is offset by the callability, interest-rate, and other risk factors that come along for the ride. And while some investors might be perfectly willing to take on these risks, there are additional complications to consider.

Why Companies Issue Preferreds, and Why They Might No Longer Do So
As Morningstar closed-end fund Analyst Cara Esser explains in this article, most preferreds are issued in the form of trust preferred shares, and most of those are issued by banks. Shares are backed by a bond issue and held in a trust, often by a bank holding company. This structure allows the issuer to take tax deductions on the bond interest payments. At the same time, the trust preferred shares are counted as Tier 1 capital, meaning they help fulfill requirements that banks have enough of a capital cushion in place to safeguard against losses. However, changes soon to take place could severely diminish the appeal of this practice.

As of Jan. 1, 2013, banks will no longer be allowed to count trust preferred shares as Tier 1 capital. As a result, banks not only may stop issuing preferred shares, but many might call in outstanding shares that no longer help them meet capitalization requirements. In addition, some banks claim that the new rule triggers a provision allowing them to call preferred shares even sooner than five years after their date of issue. That would allow them to call preferred shares issued at much higher interest rates during the financial crisis of 2008-09, when banks were in desperate need of capital, and issue new ones at today's lower rates. Doing so would deprive investors holding those shares of additional years of guaranteed income they thought they'd locked in, not to mention any price appreciation on the shares, which issuers could buy back at par value.

As you can see, preferred shares carry multiple risks, not least of which is an uncertain future in light of these new financial regulations. That isn't to say they don't have any merit as a potential source of extra yield for income investors. But moving ahead with eyes wide open and well aware of factors shaping the market is essential.

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