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Today's elevated share prices for high quality[1] preferred stocks have left many preferred stock shareholders, who are looking at huge but unrealized capital gains building up in their brokerage cash accounts, wondering if they should sell and pocket the gains now while they can.

We all know that the market price pendulum swings both ways which is actually one of the many positive aspects of preferred stock investing. During times of low prices, preferred stock investors enjoy higher dividend income as yields increase and coupon rates offered by new issues become more generous. When prices go back up, shareholders have selling opportunities that bring income in the form of capital gains to those who choose to sell. Income generation swings back and forth between increasing dividends or increasing capital gains.

But those who realize their capital gains by selling their shares face a dilemma - since prices are so high, what do you then buy if you are to reinvest[2]?

Should You Sell?

If I were to offer you $100 today or the same $100 two years from now, which would you pick? Since an unknowable future has more risk, most people would take the same money sooner rather than later. That can become important when deciding whether or not to sell a preferred stock.

The decision that preferred stock investors have to make is whether or not it is in your best interest to sell the shares that you purchased when prices were much lower. After all, the quarterly dividend payments stop once you sell your shares.

But you will likely realize between one and three years of income in the form of a capital gain by selling at today's high prices.

Get Paid Twice On the Same Principal

By selling your shares and collecting a capital gain, rather than collecting future quarterly dividends, you are essentially being paid the same money but in advance. So any further returns that you earn by reinvesting your original principal are in addition to the return that you have already pocketed in the form of capital gain cash.

Even if you reinvest in another preferred stock that provides a lower dividend payment than what you were making on the sold shares, you are getting paid twice on the same principal over the reinvestment period.

Take a look at this example.

Let's say you purchased PSA-Q from Public Storage (PSA) a year or so ago when it was first introduced for $25.00 per share. PSA-Q pays a 6.50% annual dividend (coupon) so that's $0.41 per quarter of dividend income for every share that you own.

PSA-Q is selling for an unheard of $28.34 today (July 16, 2012) so by selling, you will realize a $3.34 capital gain per share.

PSA-Q Public Storage preferred stock

That's over two years' worth of dividend income (8.1 quarters). By selling now, you earn the same income on your $25 principal but do so in advance (you earn the same money sooner rather than later).

The Buy Side

Having just sold your PSA-Q shares, you now have to decide whether or not to reinvest. By not reinvesting for another two years (and collecting zero return on your newly received cash) you will still be ahead of where you would have been had you not sold PSA-Q to begin with.

Or, you could reinvest your $25 principal and pile on more dividend income.

To get paid twice on the same $25 principal, risk averse preferred stock investors often look for an investment grade preferred stock that is available for a market price at, or very near, its $25 per share par value[3]. It would also be great (but not required) to choose an issue that is call protected (i.e. does not reach its call date) for another couple of years or so.

An investment grade, call protected, sub-$25 preferred stock in today's market is going to provide an annual dividend yield of about six percent. That's not as high as what you were earning with the PSA-Q shares that you just sold, but remember - since you have already been paid for the next two years (in our PSA-Q example), whatever you can now earn by reinvesting your principal is piled on top. By reinvesting, you get paid twice on the same principal for the same time period.

One example (and that's all this is) of a purchase candidate is AEH, a traditional preferred stock from AEGON (AEG). AEH can be purchased for $24.95 (July 16, 2012) and generates a 6.375% annual return (coupon).

AEH AEGON preferred stock

AEH does not become callable until June 15, 2015; that's another three years of call protection. AEH's 6.375% coupon provides shareholders a quarterly dividend of $0.40 per share. Because you are investing the same $25 principal, your total income for the next eight quarters (two years) is $6.54 ($3.34 in capital gains from your sale of PSA-Q plus $3.20 from AEH's next eight dividends). That's equivalent to $0.82 per quarter compared to $0.41 per quarter had you just held on to your original PSA-Q shares and not sold.

You just got paid twice on the same $25 principal for the next eight quarters.

Keep An Eye Out For Downward Price Pressure

Going forward, keep an eye on the events that tend to put prolonged downward pressure on the market prices of fixed-income securities such as increasing interest rates. While any initial price drop that comes along is unlikely to outpace the double income that you are earning, you want to be in a position to avoid too much erosion if prices head down in a significant way.

As illustrated in the Seeking Alpha article titled "Preferred Stock Investors: How Afraid Should You Be Of Increasing Interest Rates?" interest rates and market prices of fixed-income securities tend to move in opposite directions. The Federal Reserve has committed to our current low rate environment until at least late-2014 (see article) but continued diligence is called for here. If it starts to look like prices are going to be heading back down, you would want to consider selling your AEH shares (in this example) to protect your downside.

Investors have to invest in the market that is in front of us at the time we are faced with making a decision. Today's market favors sellers. For preferred stock investors wishing to take advantage of today's market, selling is going to be part of the equation. No way around it. The only question is that, once you collect your "advance payment" by selling, how much additional income do you want to pile on top by reinvesting?

Footnotes:

[1] "High quality" preferred stocks are those that meet the ten risk-lowering selection criteria from chapter 7 of my book, Preferred Stock Investing. For example, high quality preferred stocks have investment grade ratings and the cumulative dividend requirement.

[2] Source for all preferred stock data in this article: CDx3 Notification Service database, Preferred Stock Investing, Fourth Edition, see PreferredStockInvesting.com. Disclaimer: The CDx3 Notification Service is my preferred stock email alert and research newsletter service including data for all preferred stocks and Exchange Traded Debt Securities traded on U.S. stock exchanges.

[3] In the event that the issuing company redeems ("calls") your shares in the future, shareholders will receive the par value ($25) per share in cash. Those who avoid buying shares for more than $25 per share add a layer of protection to their principal plus set themselves up for a capital gain in the event of a downstream call.

Source: Preferred Stock Investors: Is It Time To Sell?