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With this article we introduce Doug K. Le Du, an expert in the field of preferred stock investing. For the past nine years, Doug has been researching and writing on preferred stock issues and in 2006 authored the book Preferred Stock Investing. Doug welcomes your comments and feedback.

At a time when the Federal Reserve’s policies have decimated savings accounts, savvy preferred stock investors continue to earn 7% yields from the highest quality preferred stocks at what many agree is acceptable risk.

The Fed’s low rate policy has pushed the interest rate on savings (bank CD and money market deposits) down to a point where inflation and taxes entirely consume any gains and then some. With inflation now at 3.87% and 24-month bank CDs only yielding an average of 1.28%, savers are losing almost 2.6% per year on that bank CD before paying taxes on the interest.

Lower Risk, A Broad Selection of Issues

Many companies issue two types of stock: common, which we are all familiar with, and preferred. Both can be purchased on the New York Stock Exchange, typically using a unique trading symbol. Over time, a given company can issue several “series” of preferred stock (series A, B, etc.) in order to raise cash for various projects. Those owning a company’s preferred stock are always paid its dividends (usually quarterly) first before those owning the same company’s common stock, hence the name “preferred,” so preferred stock investors have less risk of an unpaid dividend.

This feature of preferred stocks can make those issued by real estate investment trusts (REITs) particularly attractive. By law, REITs are required to distribute at least 90% of their taxable profits to shareholders. They do so starting with their preferred stock shareholders.

There are about 1,100 preferred stocks currently trading on U.S. stock exchanges. While that might seem like a lot, most are issues that, for a variety of reasons, risk-averse preferred stock investors will have no interest in. Preferred stock investors are generally more drawn to the security of the “highest quality” preferreds (those with the highest ratings and risk lowering provisions built in). Today, the highest quality preferred stocks are providing investors with an average annual dividend yield of 7% (equaling their long-term average).

Three Criteria Eliminate The Pretenders

The complexity of preferred stocks largely appears with a group of issues that most risk-averse investors would never consider investing in. Applying three simple criteria eliminates these issues and the risk and complexity that come with them.

Criteria #1 - Investment Grade: By limiting the choices to those preferred stocks with a Moody’s investment grade rating, we cut the list almost in half in one shot, down to about 600 issues (you can use S&P ratings if you wish; the result will be about the same). With 600 investment-grade issues to pick from, most risk-averse investors would rather not fool around with “speculative grade” alternatives.

For example, Kimco Realty (NYSE:KIM) develops neighborhood shopping centers and its Series G preferred stock (KIM.PG) is rated investment grade; Baa2 by Moody’s* and BBB- by Standard and Poor’s. Not the top of the scale, but KIM.PG offers a 7.75% annual dividend to its shareholders.

Criteria #2 – Cumulative Dividends: With common stocks, if the company decides not to pay a dividend, you’re out the money. But many preferred stocks have a “cumulative” dividend provision, meaning that if the issuing company misses a dividend payment to you, it still owes you the money downstream (its obligation to pay you accumulates). Limiting our choices to just cumulative dividend preferred stocks eliminates another 200 pretenders.

Self-storage company Public Storage (NYSE:PSA) provides several examples of high quality preferred stocks such as its Series W with a 6.5% coupon rate (PSA.PW on Yahoo Finance). PSA.PW is an investment-grade rated traditional preferred stock that offers a cumulative 6.5% annual dividend.

These two criteria (investment grade and cumulative dividends) are pretty easy for most risk-averse investors to warm up to. We are down to about 400 remaining candidates.

Criteria #3 – Minimum Rate of 6.5%: Historically, the highest quality preferred stocks carry annual coupon rates between 6% and 9%. Not too bad compared to that 1.28% being paid by bank CDs. But rates go up and down over time and you want to be sure that you always have some breathing room if rates fall too far. A 6% preferred stock (i.e., the bottom of the barrel) can become hard to sell once rates start rising again and higher paying alternatives are introduced. Preferred stock investors can avoid this pitfall by simply sticking with preferreds that offer a fixed dividend rate of at least 6.5%, giving you time to sell once rates bounce off of 6% and begin heading back up.

By eliminating candidates that offer less than a 6.5% annual dividend, we are left with about 150 extremely high quality preferred stocks to pick from and now have additional principal protection at the low end as rates rise and fall over time.

Less Exposed To Quarterly Profit Fluctuations

A common stock dividend is a distribution of a company’s profits, assuming there are any. Common stock dividends are therefore subject to change or cancellation at any time.

Conversely, preferred stock dividends are set upon issuance, committed to and planned for in advance and are therefore considered more reliable than the common dividend, which tends to reflect the long-term growth of quarterly profits. Consequently, the income earned by preferred stock shareholders tends to be much more stable.

Add A Capital Gain From Your “Built-In Buyer”

Usually, the issuing company of a high quality preferred stock is allowed to retire (“call”) the shares five years after introduction. They may or may not do so depending on conditions at the time. But knowing this provides preferred stock investors with an enormous double benefit.

In the event of a call, shareholders will receive the “par” value (usually $25) per share in cash from the issuing company. So if you always purchase your shares for less than $25 each you (a) add another layer of principal protection to your investment, plus (b) position yourself for a future capital gain in the event of a call. The issuing company, in that event, becomes your “built-in buyer.”

There are always plenty of high quality preferred stocks available to pick from for less than par (on October 21, 2011 there were 28 such issues). I'll share more information in Part Two of this article on Tuesday.

* Moody’s investment-grade ratings range from (highest to lowest): Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2 and Baa3.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Preferred Stock Investing: A Simple Guide To 7% Yield