OVER the last month, yields of Treasury bonds have fallen. And yields on junk bonds — often known euphemistically as high-yield bonds — have been at historically low levels for years.
What’s a yield-hungry investor to do?
Some strategists suggest a look at financial securities that aren’t labeled as bonds but behave very much like them: preferred stocks.
“These are good for the income-oriented investor who is trying to maximize yield without having to buy noninvestment-grade bonds,” said Kevin J. Conery, a fixed-income strategist at Merrill Lynch who specializes in preferreds. Merrill Lynch recommends that individual investors allocate as much as 10 percent of their fixed-income portfolio to them.
For starters, “preferred stock” is one of the great misnomers in the world of investing. Although these stocks trade on the major exchanges, they are in many respects fixed-income investments. That is because the dividend payments for preferred stocks are set when the shares are issued and do not rise over time. And most of them become callable five years after they were issued. This means that if interest rates fall, a company can take back the shares and pay you the price at which they were issued.
A company has to pay somewhat higher dividends to its preferred stockholders than to its bondholders, because preferred stocks are subordinate to bonds. In a worst-case situation, if a company declares bankruptcy, the owners of its preferred stock would rank behind its bondholders, though ahead of its common stockholders.
For that reason, investment strategists say that you should consider preferreds as an alternative to owning junk bonds. And they generally advise against dabbling in the preferreds of companies with shaky credit. Josh Peters, an equity strategist at Morningstar, said that individual investors should stick with preferreds with a credit rating of triple-B or better. True, Mr. Peters said, preferreds have more protection than common stock in a bankruptcy, but in some cases, that may not amount to much. “Do you really want to be the second-to-the-last person to jump off the Titanic?” he asked.
Fortunately, most preferreds are investment grade, and the handful of mutual funds that specialize in them focus on investment-grade securities. Indeed, strategists say the recent beauty of preferreds has been their relatively stable share price. That stability derives from investors’ knowing the level of future dividends, so long as the companies continue to meet all of their debt obligations. For common stock, by contrast, companies can cut dividends during lean times without any warning.
“If a company misses earnings estimates by a penny, that might affect the common stock, but not the preferreds,” said Bernie Sussman, a portfolio manager at Spectrum Asset Management, a money management firm based in Stamford, Conn., that specializes in preferred securities. “On the other hand, anything that would affect the creditworthiness of a company, like a downgrade, could hurt its preferreds.”
Generally, preferreds are susceptible to the same risk factors as bonds, like inflation and rising interest rates. Mr. Sussman says preferreds also tend to be less volatile than bonds over time. Preferreds usually fare better than bonds when interest rates are rising, he says, and underperform bonds when interest rates are falling. Bond prices and their yields move in opposite directions.
Mr. Sussman attributes the lower volatility of the preferred market to the fact that individual investors play a bigger direct role in it than they do in the market for corporate bonds, which tend to be held through bond funds. “Individual investors don’t react to the moment-to-moment price movements” the way that institutional investors or bond fund managers might react, he said.
Individual investors may find preferreds easier to own than corporate bonds. Preferreds can be bought and sold on the major exchanges, rather than in the bond market, which is less transparent. And shares are usually priced at $25 each when they are issued, versus the $1,000 price for most new corporate bonds.
For tax purposes, there are two flavors of preferred stocks.
Many preferreds have dividends that are eligible for the qualified dividend tax rate — 15 percent for most investors — because the dividends are paid with after-tax dollars. But most preferreds pay dividends that are taxed at an investor’s federal income tax rate. The companies write off these payments, so from the perspective of the Internal Revenue Service, they are more like the interest that is paid to corporate bondholders.
Generally, the preferreds that do not pay qualified dividends yield a bit more than those that do. So strategists recommend holding preferreds with qualified dividends in taxable accounts, and putting those that do not pay qualified dividends into tax-advantaged accounts like I.R.A.’s. If you are buying an individual security, the prospectus will say whether it pays qualified dividends.
A few mutual funds invest mostly or entirely in preferred securities. They are closed-end funds, which means that they can trade at a premium or a discount to their net asset values. The closed-end structure permits the fund managers to use leverage, buying shares with borrowed money to bolster the funds’ returns. But leverage cuts both ways. It helps the yield and the total returns of the funds when interest rates are generally stable or falling, but it can exaggerate losses if interest rates rise sharply.
MR. SUSSMAN of Spectrum Asset Management is co-manager of three closed-end preferred funds — Nuveen Quality Preferred Income I, II and III — for Nuveen Investments, the mutual fund company based in Chicago. The funds are leveraged about 30 percent and have expense ratios of around 1 percent. Mr. Sussman says the funds focus on the higher-yielding preferreds — all three funds now yield around 7.6 percent — so most of the income would not be eligible for the lower dividend taxes.
John Hancock offers funds called John Hancock Preferred Income I, II and III . Each has a slightly different yield, and all use about 30 percent leverage. Gregory K. Phelps, co-manager of the funds, said that most of their dividends were not eligible for the favorable tax treatment.
Mr. Phelps is also co-manager of the Patriot Preferred Dividend fund, which does distribute most of its income in the form of qualified dividends. The fund is also leveraged about 30 percent and yields 6 percent, versus 6.7 to 7.5 percent for the other three John Hancock funds. But Mr. Phelps said the Patriot fund could give taxpayers a better after-tax equivalent yield if it is held in a taxable account. The Patriot fund charges about 2 percent in annual expenses, roughly double those of the other three funds.
Of course, some investors prefer to buy individual securities. Mr. Conery of Merrill Lynch says he thinks that preferreds paying qualified dividends, when held in taxable accounts, are the most attractive part of the preferred market right now. For many investors, he said, these can complement their municipal bond portfolios.
For example, the Royal Bank of Scotland has some preferreds that Merrill Lynch recommends to investors who are looking for qualified dividends. Recently, the bank’s preferreds with a call date of Dec. 31, 2010, have been trading around $25, or par, which gives them a yield of 6.25 percent.
If investors decide to go it alone in buying preferreds, said Mr. Phelps of John Hancock, they need to do a lot of homework.
First, they need to consider whether the issue’s dividends qualify for the lower taxes and whether they plan to hold the shares in taxable or tax-advantaged accounts. He also advised investors to stick with issuers with strong credit ratings and to buy shares with three to four years of call protection.
Finally, he recommended buying preferreds at a price around par. Or, better yet, buying them at a discount: “Then I think investors should be able to sleep very well at night.”
|
