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The
Silver Lining to a Falling Dollar
Despite the U.S. national debt, there is a silver lining for income
investors. This massive spending, combined with movement out of U.S.
Treasuries, is going to take its toll on the dollar, and
international income investors could reap the rewards in the form of
higher dividends. |
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| A
Closer Look at Preferred Stocks |
Published: May 8, 2005
Fasten your seatbelts -- you're
about to enter the wonderful world of preferred stocks.
What exactly are preferred stocks? Basically, preferreds are a cross
between a stock and bond. These stocks are called "preferred"
because they receive higher priority (versus common stock) when it comes
time for a company to make dividend payments.
Preferred stocks trade just like common shares on one of the major stock
exchanges. They also trade under basic ticker symbols just like common
stocks. Although you may hear these stocks referred to by a host of
different names -- Quips, Corts, Cabcos, Pines, Toprs, Notes -- all of
these are still preferreds.
Juicy Dividend Yields
It's often difficult to find solid information on many preferred stocks.
In addition, because of their differing structure, preferreds can
sometimes be a bit complicated. However, their juicy yields make them
well worth the effort. In fact, according to the PreferredsOnline Index,
which compiles data on all actively traded preferreds, the average
preferred stock now offers a healthy 6.8% yield. By comparison, the
1.9% yield offered by dividend payers in the S&P 500 looks downright
puny. In addition, even the 10-year "AAA" corporate bond with
its 4.8% yield can't hold a candle to preferreds.
The nice thing about preferreds is that even though their share prices
can rise and fall, if you hold your preferred shares until maturity,
then you'll get back your capital. Like bonds, preferred shares have a
face value -- meaning the price at which they were issued. Most
preferreds have a face value of $25 per share. If you hold your
preferred shares until they mature, then you'll get back this amount
(unless the company goes bankrupt or liquidates).
Reliable Income
Preferreds are ideal for income investors who are looking for stability
and above-average dividend yields. When analyzing a preferred shares,
it's important to understand that their dividends are fixed to the
stock's issue price, not to company earnings. As a result, preferred
shares tend to be much less volatile than common shares -- preferreds
don't fall as much when company earnings decline, and they don't rise as
much when earnings increase. In fact, most investment-grade preferreds,
issued at $25, trade in a close range between $22 and $26.
Although that tight trading range applies to most preferred shares, we
sometimes see exceptions to this general rule. Preferred shares can move
sharply higher or lower as a result of a change in the underlying
company's credit rating. For example, General Motors' debt was recently
hit by a downgrade, causing the company's preferred shares to plummet.
As a result, the yield offered by these stocks rose, giving shareholders
a chance to lock in much higher yields.
When preferred share prices fall, yields rise. However, so does the risk
of default. Most companies can suspend dividend payments on preferreds
for up to five years if they run into major trouble. They could also
default on their preferred stock obligations entirely if they go
bankrupt.
Now Is The Time To Lock In Yield
Most preferred shares have long maturity dates of 30 to 40 years. As a
result, they often provide investors with many years of reliable income.
However, this long time to maturity also makes preferred shares highly
sensitive to changes in interest rates. When rates rise, preferred share
prices tend to fall. This is the exact scenario we've seen over the
course of the last several months, as expectations of higher rates have
driven down prices for a variety of preferred shares. With this as a
backdrop, now may be an opportune time for investors to start
considering preferred stocks.
Calling All Prefs!
Like bonds, preferreds are callable, meaning the issuer can buy them
back from you at the issue price before they mature. Most preferreds can
be called five years after they are issued. Companies usually repurchase
their preferred shares during periods of declining interest rates, and
they do so in order to refinance with cheaper long-term debt.
In the current environment, which is marked by rising interest rates,
investors needn't be too concerned about their shares being called.
Still, the longer a preferred stock's time to maturity and the closer
it's trading to the call price, the better.
How Much Risk?
Preferred shareholders get higher priority versus common shareholders
when it comes time for a company to pay dividends. However, it's
important to remember that bondholders receive top priority for a
company's assets (ahead of both preferred and common shareholders) when
a company enters into bankruptcy. In most corporate bankruptcy
situations, bondholders are able to make a claim on a company's assets.
In doing so, they are often able to recover at least a portion of their
initial investment. By contrast, equityholders usually walk away with
nothing.
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With this in mind, before you
buy a preferred stock, you should make certain to analyze the underlying
firm's credit quality. This will help you gauge the safety of all future
dividend payments you hope to receive from the preferred stock. Ask
anyone who bought Enron Corp.'s preferred shares a few years ago about
the importance of staying up to date on a firm's credit quality.
Leading credit rating agencies, the most notable being Standard &
Poor's and Moody's, assign ratings to thousands of firms. In doing so,
they assess each particular company's default risk. Risk levels often
change over time, so it's a good idea to look for the most current debt
rating. Both agencies have investment-grade and speculative ratings, but
each uses a different grading system.
In the table below you'll find a list of the current rating scales for
both S&P and Moody's:
| Moody's |
S&P |
Meaning
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Investment
Grade Bonds
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| Aaa |
AAA |
Bonds of the
highest quality that offer the lowest degree of investment risk.
Issuers are considered to be extremely stable and dependable. |
| Aa1,
Aa2, Aa3 |
AA+,
AA, AA- |
Bonds are of
high quality by all standards, but carry a slightly greater
degree of long-term investment risk. |
| A1,
A2, A3 |
A+,
A, A- |
Bonds with
many positive investment qualities. |
| Baa1,
Baa2, Baa3 |
BBB+,
BBB, BBB- |
Bonds of
medium grade quality. Security currently appears sufficient, but
may be unreliable over the long term. |
|
Non
Investment Grade Bonds (Junk Bonds)
|
|
| Ba1,
Ba2, Ba3 |
BB+,
BB, BB- |
Bonds with
speculative fundamentals. The security of future payments is
only moderate. |
| B1,
B2, B3 |
B+,
B, B- |
Bonds that
are not considered to be attractive investments. Little
assurance of long term payments. |
| Caa1,
Caa2, Caa3 |
CCC+,
CCC, CCC- |
Bonds of
poor quality. Issuers may be in default or are at risk of being
in default. |
| Ca |
CC |
Bonds of
highly speculative features. Often in default. |
| C1 |
C |
Lowest rated
class of bonds. |
| - |
D |
In default. |
Taxes Take A Bite
Given the current structure of many preferred shares, only about 20% of
today's preferreds qualify for the recently lowered 15% tax rate. As a
result, the dividends paid by most preferreds are treated as interest
income and are taxed at the ordinary income tax rate up to 35.6%. The
best place for many preferreds, then, is in tax-advantaged or
tax-deferred accounts such as IRAs.
For More Information
If you know the ticker symbol for a particular preferred stock, then you
can easily obtain daily pricing and yield information from your online
broker, as well as from a variety of free financial websites, such as
Yahoo or MSN. Quantumonline.com is another free site that provides
complete lists of preferred stocks with links to further information on
each stock. And finally, I also provide a regular analysis of various
high-quality preferred stocks in my monthly High-Yield
Investing
newsletter.
Important Note: To view the
remainder of this article, in which Carla Pasternak provides an in-depth
analysis of several of her favorite preferred stocks, you'll need to
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