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Part 1 of this article provided three simple criteria that, when applied to the nearly 1,100 preferred stocks trading on U.S. stock exchanges, serve as a proven effective filter for identifying the highest quality preferred stocks. Once applied, the filter brings our list of candidates down to a more managable 150 issues that are providing preferred stock investors with an average yield of 7%. These are the highest quality preferred stocks available to risk-averse income-oriented investors.

Diversification and Types of Preferred Stocks

The highest quality preferred stocks that we have described here are offered by big investment banks, regional banks, insurance companies, real estate outfits (such as apartments, shipping facilities, hotels, self-storage, hospitals, data centers and shopping centers) and utilities. Eleven segments in all. To diversify beyond that, you will have to increase your risk by relaxing one or more of the above criteria. For example, if you want to extend your choices to such businesses as high tech, telecommunications or airlines, you will have to remove the cumulative dividend criteria. All preferreds issued by these types of businesses have non-cumulative dividends, substantially increasing your risk.

There are only three types of preferred stocks – traditional, trust and third-party trust. You may have heard other terms such as redeemable, convertible or tax-advantaged. Those are characteristics of preferred stocks, not types. From the investor’s perspective, the dividends received from the three types are generally the same although some traditional preferred stocks pay dividends that qualify for a special 15% tax rate. Risk-averse preferred stock investors generally avoid these since none of the tax-advantaged preferred stock issues is able to meet the above risk-lowering criteria or pays miserly dividends (well below our 6.5%) that eliminate any tax benefit.

Managing Other Risks

Like any other investment, bankruptcy of the entity you are investing in is always a risk. But if you had used the above criteria to buy preferred stocks prior to the Global Credit Crisis, you might be surprised by the results you would have seen once the crisis was over (these criteria were first published in the first edition of my book, Preferred Stock Investing, in 2006).

At the onset of the crisis (2007) there were 70 preferred stocks trading from 11 big banks. The simple risk-lowering filter presented here screened out the 57 preferred stocks from the banks that failed and let through the 13 preferred stocks that continued to pay dividends to investors; a 100% success rate during the most extreme conditions.

Another risk is that the issuing company of a high quality preferred stock will miss a dividend payment to you. Has it happened? Yes, once. Looking at all of the high quality preferred stocks issued since January 1, 2001, auto industry lender Citizens Republic Bancorp (CRBC), having survived the Global Credit Crisis, deferred the dividend on its Series A trust preferred stock on January 28, 2010 when the U.S. auto industry nearly failed. This regional bank has since returned to profitability and, since its Series A preferred stock is a cumulative preferred stock, now owes the missed dividends back to shareholders.

Also, market prices of preferred stocks tend to move in the opposite direction of rates. When rates increase, prices for high quality preferreds will tend to fall. Like most other investments, if some type of emergency arises and you need lots of cash unexpectedly, you may be forced to sell at a loss during such times. Otherwise, preferred stock investors use such a period to add dividend-paying shares at low prices as yields move above 7%.

Where To Find The Information

Two of the three criteria, cumulative dividends and the dividend rate, generally appear right on page 1 of the prospectus, so don’t worry about getting too bogged down in these documents.

There is a variety of ways to get your hands on an electronic (searchable) copy of the prospectus, some for free while others request a fee. The Investor Relations section of the company’s website may include a free downloadable copy, so start there. Your broker may also be able to email you a copy. And the U.S. Securities and Exchange Commission website (www.sec.gov) allows you to search for filings by company name (tedious but free).

A company’s preferred stock ratings (Moody’s, S&P or other) are occasionally posted on the company’s website. Otherwise, ask your broker for the current rating. Fee-requested sites include the CDx3 Notification Service at www.PreferredStockInvesting.com (my preferred stock newsletter and research service) and QuantumOnline.com (which relies on the honor system for your contribution). Both provide Moody’s and S&P ratings of preferred stocks.

Respectable Returns At Acceptable Risk

The Federal Reserve has officially declared their policy commitment to low interest rates until at least the middle of 2013. Savers should not expect the erosion of their income and principal caused by this policy to stop for at least another two years.

For those considering making a change, investment grade, cumulative preferred stocks with a coupon rate of at least 6.5% and purchased for less than par ($25.00 per share) currently offer a respectable 7% annual return at what many view as an acceptable level of risk.

Source: Preferred Stock Investing: A Simple Guide To 7% Yield - Part 2