When Preferred Securities Make Sense

Investors seeking income might want to take a peek at preferred-stock funds.

Buyers may reap handsome yields of around 6% with advantageous tax treatment on distributions. Still, you need to understand the nuances of preferred stock to get the most from it.

What is preferred stock? It is a hybrid security that is a cross between equity and debt. Like debt, it pays a fixed amount of interest, and holders get paid before any common-stock dividends are distributed. But like equity, it tends to have larger price swings to both the upside and the downside.
These securities are often issued by highly indebted companies that need lots of capital to operate efficiently. Broadly speaking that's banks and other financial institutions, telecommunications companies and utilities.

Risks to Weigh - Because preferred stock is in many ways priced like bonds, rising interest rates pose a risk to those who invest in it. When interest rates jump, the value of preferred stock drops, just like it does with bonds.

With bonds, the further away the maturity date is, the bigger the interest-rate impact will be. Because preferred is often like bonds with no maturity, there can be an even bigger price risk when interest rates rise, says Guy LeBas, chief fixed-income strategist at Philadelphia-based investment bank Janney Montgomery Scott LLC. Still, he sees it as a good risk these days.

Yields on preferred stock vary but are around 6% a year now, which should be plenty of cushion against loss of principal based on what most strategists predict for interest rates this year, says Mr. LeBas. He expects only a modest rise in long-term rates.

Fund Choices - Fund investors seeking preferred exposure can choose either ETFs or actively managed mutual funds. On the ETF side, look at PowerShares Financial Preferred (PGF), PowerShares Preferred (PGX) and iShares S&P U.S. Preferred Stock Index (PFF). Morningstar analyst Abby Woodham likes the latter, saying its expense ratio, 0.48%, "is the lowest of its peers."

In the five years through February, the iShares ETF returned an average 5.5% a year versus 4.9% for the Standard & Poor's 500-stock index.

Many, but not all, preferred shares produce qualified dividend income that is taxed at a preferential rate of up to 20% versus the ordinary-income rate of as much as 39.6%.


Source:  Simon Constable, Wall Street Journal

PFF and PGX are components of the D2 Capital Management Multi-Asset Income Portfolio.

The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

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