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It can always be tempting when you see a high yield. Most income investors such as myself like preferred stocks because of the stable dividend that comes with it. However, we have to be very careful when we see certain yields.

Awhile back I wrote an article on Goodrich Petroleum (NYSE:GDP). I told investors that the new 10% preferred was fairly risky and investors should stay away. While a 10% annual dividend sounds great, the risks outweigh the return.

When I wrote the article, the series C was trading right around par value. The preferred is now trading at nearly a $1 more than par. So investors are willing to lose money if the preferred is called. Why is this?

Maybe it's because Goodrich is becoming a safer company to invest in. The market psychology behind preferreds trading above par is due to two factors. One is the perceived safety of the underlying company and the other is the hunt for high yield.

So has the underlying company become safer?

Here is what we do know. The company is doubling its acreage to 320,000 acres. The idea is that they want a more diverse product mix by focusing on oil. However, this means nothing to preferred investors. The company has less than $3 million in cash on its balance sheet.

This means that the only way that the company can afford to pay the dividends on the preferreds is by tapping it borrowing facility. Currently the facility has around $168 million (upon closing of the TMS acquisition) left on it that the company could borrow.

It's likely that the borrowing base will continue to be used to pay the preferreds. As an income investor, this just doesn't seem like something that would help me sleep at night. I became even more concerned when the company began to issue another preferred offering.

Goodrich has priced another preferred offering last week. The company plans to raise a $120 million through its new series D preferred. The yield on par value will be 9.75%.

I must actually congratulate management on this. They have issued a 25 bps cheaper offering because the markets seem to still be pretty hungry for yield. However, I believe the market is just ignoring the problems with these preferreds. Remember, the company had negative free cash flow of -$33 million at the end of June.

My concern is that investors believe the 9.75% yield on these preferreds is considered a sufficient return for the risk. I just don't simply believe this to be the case. There are plenty of securities out there that I would rather invest in that have much better risk-reward scenarios.

Prospect Capital (NASDAQ:PSEC) is a business development company that currently yields 12.20%, which is paid monthly. Unlike GDP, the company doesn't need to borrow from a facility to pay its dividends because it makes sufficient cash flow. PSEC is also well diversified amongst various industries unlike GDP, which is simply reliant on energy. As you can see, the risk-reward in this scenario is much better.

Are you more willing to invest in a preferred yielding 9.75%, where the underlying company is losing money? Or will you invest in a security yielding 12.20%, where the company is making money?

This article isn't really meant to show why PSEC is better than GDP's preferreds, but to put the idea of risk-reward into proper context. Whenever I purchase any security, I always ask myself, am I properly being compensated for the risk that exists?

I think all investors need to ask this question. I urge investors to stay away from GDP's new preferred offering. There are much better opportunities out there. Remember, the most important part of investing in income producing securities is the ability to sleep well at night. I don't believe this is an attribute that exists with GDP.

Source: A New 9.75% Preferred - What Investors Should Know