Uncovering Preferred Stocks

So what is a preferred stock anyway? It's capital stock, issued by a corporation, just like its better known counterpart, so-called common stock. But unlike common stock, preferred stock doesn't participate in shareholder votes, and it doesn't normally benefit (or suffer) from changes in earnings.

So what the heck is "preferred" about it?

Well, for one, it usually pays a fixed and more generous dividend than the equivalent common stock, and in addition, those dividends are to be paid before any common dividend is paid. But there's an asterisk -- bond interest must be paid before preferred dividends.

It's hard to think of securities that toil in greater obscurity than preferred stocks. Most newspaper listings have cut out preferreds altogether (the Wall Street Journal publishes an abbreviated list once a week). Most preferred issues don't even show up on popular financial portals, and they're hard to get to on brokerage and other financial Web sites.

Indeed, preferreds have existed primarily as a way for corporations to buy fixed-income securities from other corporations. Why? Because only 30% of the dividend is taxable.

So why would you, an individual investor, care to own them? There are three reasons:

• High, steady yield. Because they are subordinate to bonds, and because their existence may be indefinite (no required date for a company to pay back, for most), their yields are higher. For high-quality issues, effective yields can run 5.5% to 6% and higher.

  As investors pull back from chasing higher junk-bond yields, preferreds make more sense as an alternative. Also worth noting is that most preferred dividends are paid quarterly, whereas bond interest is only paid twice a year.  

• Exchange traded. As obscure as preferred stocks are, the bond market is hardly any better. At least most preferred stocks trade on major exchanges, usually in smaller $25 increments instead of the $1,000 increments typical of bonds.

Those are the pros -- now here are the cons. First, because they are hardly a consumer investment product, preferred stocks are notoriously hard to research. QuantumOnline is the best site and is free (you do have to register). Another portal, ePreferreds Online, offers a nice tool but charges $29.95 a month or, more handily, $10.49 for a single-day use.

As I mentioned above, most preferred issues technically exist forever. That means you take on some interest-rate risk -- your stock will drop if interest rates rise. Unlike bonds, which will be paid back at face value eventually, high interest rates could keep preferred stock prices low for a long time.

There are more than 900 issues tracked by QuantumOnline, the majority of which are in the utility industry. But banks, insurance companies and certain energy companies are well represented. Here are a few for starters, all of which pay tax-qualified dividends:

• Alabama Power 5.20% Preferred Series N (ALPPRN - Cramer's Take - Stockpickr). This company is a stable and prosperous subsidiary of utility giant Southern Company (SO - Cramer's Take - Stockpickr - Rating). At current prices, it pays just a little under 5.5%.
• Royce Value Trust 5.90% Preferred B (RVTPRB - Cramer's Take - Stockpickr) is issued by the popular investment trust, paying just under 6%.
• Royal Bank of Scotland $1.53 Series Preferred R (RBSPRR - Cramer's Take - Stockpickr). The current yield is 6.1% on an S&P Grade A security from this large bank.

Maybe you're not quite ready to run out and buy a preferred stock this afternoon. That's OK -- they don't go anywhere very fast.

This isn't the most dynamic or interesting part of the investing space. But it may be one for income-oriented investors -- especially those of you in high tax brackets -- to learn more about.


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