Preferred stocks and focused exchange traded funds are high-yielding hybrid investments, so with the payoff comes risk. The risk factor makes it even more important for investors to select companies that have a good credit rating and a solid track record.
"The investor who buys preferreds wants steady, reliable income," Harry Domash, publisher of the Dividend Detective investment newsletter, said in a recent MarketWatch report. "But you don't have much appreciation potential."
Preferred stocks are less volatile than ordinary shares and provide a decent income stream, like that of a high yield bond, reports Jonathan Burton for MarketWatch. Furthermore, companies pay dividends to preferred shareholders before they make payouts to common stock holders. Another plus is that these shares are taxed at the same 15% rate as common stock dividends.
However, with reward comes risk. Here are some points of caution for preferred shareholders:
- Preferreds are interest rate sensitive. In today's low-yield market this has worked in investors favor. When rates rise the price of the preferred falls (and vice versa), and an investor could be stuck with lower-valued paper that a corporate issuer may never redeem.
- When stock prices rise, preferred stock holders do not gain from the appreciation. The issuer has certain redemption rights to preferred stocks. Those rights typically include a "call" provision, where the issuer can buy out shareholders at face value after five years from the issue date. When interest rates decline, the chance of a security being called is higher because new securities can be issued at a lower yield. The opposite is true when rates rise.
- There is an amount of credit risk with preferred shares. The financial sector and major banks tend to dominate this area of the market, but even the biggest bank can have trouble. Troubled companies can suspend preferred dividend payments, and in a bankruptcy, preferred stockholders, unlike bondholders, are out of luck.
The low -yield environment is still supportive of preferred shares and focused ETFs. With a 10-year Treasury note yielding about 2%, preferred stocks are an opportunity for income seeking investors. Some preferred stock ETFs:
- SPDR Wells Fargo Preferred Stock (NYSEARCA:PSK) yields 6.39%
- PowerShares Preferred ETF (NYSEARCA:PGX) yields 6.97%
- PowerShares Financial Preferred ETF (NYSEARCA:PGF) yields 6.83%
- iShares S&P U.S. Preferred Stock ETF (NYSEARCA:PFF) yields 6.07%
iShares S&P U.S. Preferred Stock ETF
Tisha Guerrero contributed to this article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.