Whip Inflation With Preferred Stocks

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 |  Includes: PFF, PFK, TVE
by: Thomas Smicklas

As investors struggle selecting appropriate income streams for their portfolios, I believe that consideration should be dedicated to the under followed and under appreciated realm of inflation-protected preferred stock.

First, a basic explanation of preferred stocks:

A preferred stock is somewhat of a hybrid security instrument, with characteristics of both stocks and bonds. The investor is promised a stated and enticing yield (or terms as per the Prospectus) in lieu of not capturing a company's growth (as with common stock) and without the same guarantees of interest and certainty of principle as bonds.In some instances, the issuer of the preferred security can defer dividend payments at their discretion. Like bonds, preferred securities usually are blessed with a rating from a recognized rating agency.

There are three dominant types of preferred securities:

Fixed-Rate Preferred Stock is the most common type of preferred stock. If dividends are deferred for "cumulative" preferred shares, the funds accumulate and must be paid to the investor unless bankruptcy occurs.

Non-Cumulative Preferred Stock is less desirable than the cumulative preferred shares. The company does not only may defer dividends, but may escape paying them altogether. In trade-off, yields on these type of shares are usually higher than on traditional preferred securities.

Trust-Preferred Stock is a hybrid preferred security essentially constructed to exploit a loophole in the U.S. tax code. Issued beginning in 2000, these shares are created by an issuing company (or a brokerage house)which places bonds issued by that company into a trust. The trust creates preferred shares that are bought by investors. This process provides certain tax advantages to the issuer. For investors,trust preferred stock is considered safer than other preferreds because dividends are paid, essentially, from interest paid to the trust by underlying bonds.Trust-preferreds generally have a certain fixed maturity date schedule.

Preferred stock issues may be treated differently for tax purposes, have a call price and feature many other qualities which are peculiar to the security. The investor absolutely MUST understand the qualities of a preferred security prior to investment. As many preferred stocks are thinly traded, the investor should always buy with a limit order. Selling some thinly traded issues could be problematic in a market free-fall.

There are approximately thirty investment-grade preferred securities with inflation protection characteristics in the market. Many of these securities offer a more handsome payout than TIPs.Buying below the call price could result in a modest capital gain if the security is redeemed. Here are a few favorites:

MetLife Preferred Series A (METpfA
): $23.57/share, currently yields 4.29%. Inflation protection is 4.00% plus 1.00% over the three month LIBOR rate. Call price is $25.00 after 9/15/2010. Rated BBB-.

Prudential Financial Inflation-Linked Notes (NYSE:PFK)
: $25.98/share, currently yielding 3.44% (interest paid monthly). Inflation protection is 2.40% plus the current U.S. Consumer Price Index (CPI). Matures 4/10/2018. Rated A-.

Tennessee Valley Authority Series A (NYSE:TVE): $24.75/share, currently yielding 4.55%. Inflation protection is 0.84% plus the thirty year constant maturity rate (CMT). Not redeemable, matures 5/1/29. Rated AAA.

U.S. Bancorp Funding Trust IV (UBSpfD):$22.11/share, currently yielding 4.06%. Inflation protection is 3.50% floor or .60% plus the three-month LIBOR rate, whichever is higher.$25.00 call price after 4/15/2011. Rated BBB+.

Note: The few ETFs (such as PFF) featuring preferred stocks that are popular with retail investors do not make my recommended list at this time, because more than a few portfolio selections are trading over their call price. When inflation kicks up, that spells trouble.