A Preferred Share Primer
by
Nilus Mattive
When
I talk about dividend stocks here at Money and Markets,
I almost always mean common shares of a company.
But
today I want to tell you about another class of stock that
some income investors gravitate toward: "Preferred"
shares.
As
the name suggests, preferred stock gives its owner a leg
up on common shareholders, especially when it comes to
dividends.
Preferred shareholders may receive larger payments, and
companies are required to pay these dividends before
distributions are made to common shareholders.
This
DOES NOT mean the dividend is guaranteed. It simply means
that when it comes down to the wire, preferred dividends
are going in the mail before common dividends.
Should things get really bad, preferred
stockholders also get to "pick the carcass" before common
shareholders. Of course, Uncle Sam, secured creditors, and
bondholders are even further up the line.
The
dividend payments on preferreds can be fixed, adjustable,
or determined by periodic auctions. Some are "cumulative,"
which means a company must add any missed dividends to
future payments during the time the stock is held.
One
other crucial thing about preferred dividends: Only some
qualify for the 15 percent dividend tax rate. These are
known as "traditional preferred" stocks.
In
contrast, any income from "trust preferred" shares will be
taxed at your ordinary income rate. That is because they
are technically considered debt securities.
If
it's starting to sound like preferred shares are a hybrid
of common stocks and corporate bonds, that's because they
are!
Guys Like Buffett Have Made a Killing With
Preferreds Lately.
But Does That Make Them Attractive for Regular
Investors?
Some
critics argue that preferreds give investors the worst of
both worlds — limited participation in earnings growth yet
fewer rights than bondholders.
However, savvy people were snapping up high-yielding
preferred shares as markets around the world crashed. So
clearly some important market participants
believe they can be good deals.
Warren Buffett is probably the most prominent proponent of
preferreds, and two of his bets made a year ago were well
publicized:
First, on September 29, 2008, he bought $5 billion in
preferred shares from Goldman Sachs. In the bargain, he
secured a 10 percent yield. (Goldman's common shares were
yielding about 1 percent at the time!)
Then, just one week later, he plunked another $3 billion
on preferred shares from General Electric. Again, he
locked in a 10 percent yield.
Plus, in both cases he received warrants that gave him the
right to buy shares of common stock in each company. Both
agreements provide five-year windows for purchases. The
prices were $22.25 for GE and $115 a share for GS.
With
GS shares currently trading at $171, you could say
Buffett's Goldman bet has worked out quite nicely. (And I
expect the GE position to work out over the long-term,
too).
|
 |
|
Guys like Buffett can get real preferential
treatment when it comes to preferred shares! |
However, there is some truth to the notion that Buffett
and other prominent preferred investors get access to
deals that regular investors will never see. Not just
during major crises but all the time!
More
to the point: Investing in individual preferreds takes
serious research and effort.
There can be multiple classes of what appear to be the
same shares ...
Yields are not always written in stone ...
Ticker symbols and naming conventions get confusing ...
The
vast majority of the issuing companies are financial firms
...
And
the list of pitfalls goes on and on.
I
would also note that preferred shares have been extremely
volatile as investors try to get a handle on the issuing
companies' credit strength.
So
...
In Most Cases, I Still "Prefer" Common Dividend
Stocks.
However, If You Want a Stake in Preferreds, Try a
Fund ...
In
my book, common shares of dividend-paying stocks are a
better choice for most income investors, and should still
comprise the bulk of your portfolio.
They
are more readily available from a wide range of companies
in different sectors and industries ... are easier to buy
and sell ... and many still offer very healthy yields.
Meanwhile, you can get "front of the line" creditor
standing with corporate bonds. And many riskier issuers
are still offering high yields right now.
However, if you still want to dabble in preferreds, I
think your best way to go is using an exchange-traded fund
(ETF) or a mutual fund that specializes in preferred
shares.
You
will avoid most of the hassles I mentioned a moment ago
and get solid diversification in one shot. Just
remember that financials are still likely to remain a huge
component of the overall fund no matter what its label
says.
As
you'd expect, the ETFs tend to carry lower expense ratios
and are generally easier to buy and sell ... so those
would be my first choices.
There are now at least three to choose from — the iShares
S&P U.S. Preferred Stock Index (PFF), the PowerShares
Preferred (PGX), and the PowerShares Financial Preferred (PGF).
Yields are currently between 8 percent and 9 percent on
these funds.
On
the mutual fund side, note that you will not find choices
from the big-name, low-cost providers like T. Rowe Price,
Fidelity, and Vanguard. That's because it's hard for large
funds to effectively participate in the market for
preferred shares. In fact, Vanguard used to offer a
preferred fund, but ended up shuttering it in 2001 for
that very reason.
And
no matter what preferred vehicle you choose, I would
absolutely keep your overall investment limited to a
relatively small portion of your broad portfolio.
Never forget that with a higher yield almost always comes
a higher risk of loss.
Best
wishes,
Nilus |
