Wednesday, October 18, 2006

Hungry for High Yields

News Analysis
October 18, 2006

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Hungry for High Yields

Investors aiming for retirement can earn market-beating returns from preferred stocks. But they're volatile, so weigh the risks carefully

An entire generation of retirees will soon be looking for some new sources of income. While the first batch of baby boomers turns 60 this year, another 75 million are poised to hit that milestone over the next two decades. Meanwhile, nearly 37 million Americans are already above the traditional retirement age of 65, according to U.S. census data (see, 10/16/06, "Making Your Parents' Golden Years Shine").

The aging population's hunt for income is one reason a growing number of investors have poured money into preferred stocks. In the past 15 years, the size of the preferred stock market has quadrupled, to about $200 billion, according to Standard & Poor's, though that's a drop in the bucket compared to the $16 trillion stock market and the $5 trillion corporate bond market. In fact, preferred shares offer income-oriented investors some of the advantages of both stocks and bonds.

"Preferreds," as they're often known, are a kind of company stock that carries additional rights beyond those of common stocks (see, 5/12/06, "Preferred Investors"). Ideally, preferreds allow shareholders to grab higher yields than they could find in other asset classes. The shares require less capital outlay than bonds, and their low correlation to other asset classes can help diversify an investors' portfolio.

Still, preferreds can also be complicated, volatile, and risky. Some analysts and financial advisers say investors should stay away from the asset class altogether. "They're often sold to unsophisticated investors because the high dividend sounds attractive, and that makes them easy to sell," says Dan Danford, president of St. Joseph (Mo.) investment advisory firm Family Investment Center.

This week's Five for the Money looks at five tips for wresting income from the preferred stock market without getting burned. As always, investors should do their homework before buying any securities.

1. Know your asset class

Preferreds tend to act more like long-term bonds than like stocks, and they come in a variety of flavors. Investors favor them for their high dividends, which are typically guaranteed. The average yield of the S&P U.S. Preferred Stock index is 6.4%, compared to 5.4% for the Lehman Aggregate bond index and 1.8% for the S&P 500 index.

Just don't buy preferreds expecting capital appreciation, money managers warn. The price return value of the S&P U.S. Preferred Stock Index was essentially unchanged during the three years ended in September, 2006, even as the total return value of the index jumped almost 22%.

Like long-term bonds, preferreds can swing in price based on interest rates or changes in the underlying company's credit rating. Investors who owned preferred shares of General Motors (GM) or Ford (F), for example, saw the value of their holdings tumble when the automakers' credit ratings fell to junk status in 2005 (see, 5/5/05, "GM, Ford Fall on Ratings Downgrade to Junk"). "People have to understand that they're getting a volatile investment," says Tom Meyer, chief executive of Marlton (N.J.)-based Meyer Capital Group. "If they can overlook that and take the coupon, that's fine."

Preferreds can also be a serious commitment. While most are issued with maturities of 30 years or more, some preferreds are perpetual, which means there's no maturity date. The market for preferreds is also less liquid than for common stock, so investors might face a wider spread between buy and ask prices.

"'Long-term' with preferreds tends to mean 'forever,' so you want to be sure you're paid for the risk," says Susan Fulton, president of Bethesda (Md.) investment advisory group WealthTrust FBB.

2. Look at the fine print

Even more than other securities, preferreds require investors to study their prospectuses, or at least hire a financial adviser who will. Each preferred involves a laundry list of variables that could each make the difference between a smart investment and a money-losing one.

First, investors need to know a preferred's "call date." Preferreds typically have provisions that allow the issuing company to "call," or redeem, the shares after a certain period of time. If share prices go above a certain amount (the call price), the issuer may call the shares, sometimes before a shareholder has been drawing yield long enough to make the investment worthwhile. Look for preferreds with call dates at least three years out, analysts say.

Call provisions mean it's not enough for investors to know a preferred's stated yield. For preferreds trading above their call price, investors will also need to calculate relative yield, also known as yield to call. This value is the yield that would be realized on a preferred if it were redeemed on the call date.

Preferreds also differ from each other in how they treat dividends. Investors will want to focus on "cumulative" preferreds, as opposed to their "non-cumulative" brethren. Cumulative preferreds entitle shareholders to receive all current and past dividends before common stock shareholders. Otherwise, management could pay a dividend to common stockholders while skipping a preferred dividend, without ever having to reimburse preferred shareholders for the missed payment.

3. Stay tax-savvy

A dwindling portion of the preferred market can provide tax advantages for well-heeled investors. Dividends from certain preferred stocks are taxed at 15%, the legislatively prescribed rate for "qualified dividend income," or QDI. Non-qualified dividends are taxed at an investor's normal rate, which usually runs much higher.

Preferreds eligible for the QDI can be a good choice for high-income investors, some financial advisers say. "Investors in lower tax brackets shouldn't purchase preferred stocks that carry the 15% federal income tax limit on dividends," says John Seitzer, president and founder of Everest Wealth Management. "They would be paying for a benefit they aren't really using."

Investors not taking advantage of the QDI might want to hold their preferreds in a tax-advantaged account, such as a 401(k) plan or an IRA, some analysts say. "You wouldn't have to worry so much about the volatility of price in there if you plan on holding it long-term," says Bill Schultz, chief investment officer with Bethlehem (Pa.) investment advisory firm McQueen, Ball Assoc.

4. Run a credit check

Like corporate bonds, preferreds are subject to credit risk. Investors will want to find out the credit rating of any preferred they're considering and avoid volatile industries. Preferred stocks have a credit claim that's senior to common stocks but below that of bonds.

As a general rule, investors should stick with preferred shares of companies with high credit ratings, financial advisers say. "You really for the most part do not want to go below triple-B," Meyer says.
Even if a preferred's issuer has a solid credit rating, investors should still watch the company like a hawk. "Remember, at one time the rating agencies gave Enron bonds a good rating," says Don Martin, owner and founder of Los Altos (Calif.)-based Mayflower Capital.

5. Choose carefully

Investors can gain exposure to preferreds either individual or through a closed-end mutual fund. Analysts differ over which is better, so investors should use their own judgment.

Buying individual preferreds incurs a brokerage commission on each trade, while closed-end funds offer broader exposure but charge a management fee, typically between 1% to 2%. The John Hancock Preferred Income III (HPS) fund has a 74% exposure to preferreds as of Aug. 31 and a perfect five-star Morningstar rating. The Cohen & Steers Advantage Income Realty (RLF) and American Select (SLA) funds each also have at least 10% exposure to preferreds and five-star Morningstar ratings.

Brokerages and stock analysis firms generally don't cover preferreds, so the best place to get information on individual stocks is income-security research site QuantumOnline), financial advisers say. The site is run out of Kalispell, Mont., by founder and investment adviser Don Doan.

Financial-services companies are among the most frequent preferred issuers. Steven Huang, manager of the Schwab YieldPlus (SWYSX) fund, likes the series-J preferred shares of Fannie Mae (FNM) and also a preferred issued recently by Freddie Mac (FRE). Jim Branscome, managing director of investment analysis for S&P, points to preferred share classes of closed-end funds General American Investors (GAM) and Source Capital (SOR). Schultz of McQueen, Ball favors a recently issued Merrill Lynch (MER) preferred.

Investors may soon have another preferred option: exchange-traded funds, or ETFs. Barclays Global Investors has filed with the Securities & Exchange Commission to launch an ETF based on the S&P U.S. Preferred Stock index, while PowerShares has filed for two preferred-stock ETFs, both based on Wachovia (WB) indexes.

Either way, preferreds make the most sense as part of a broadly diversified portfolio. "You can't go sell all your bonds or stocks and hoard preferreds," says Srikant Dash, index strategist at S&P.

A preference for preferreds can provide plenty of yield for income-hungry investors, but the asset class also has its pitfalls. Investors who carefully assess which preferred stocks, if any, meet their needs are the most likely to meet their retirement goals.

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