Prefer Dividends? Why Not Look At Preferred Stock?

By Stephen D. Simpson, CFA | April 11, 2011 AAA

Everybody assumes that there is a lot of demand for, and interest in, articles and columns detailing growth stock ideas. While that is true to a point, it is also true that there is a strong interest in income ideas as well. What is interesting, though, is how relatively little there is out there about preferred stocks and their close cousin, trust preferred securities. While these are not flawless investment options, they should be a serious consideration for many income-oriented investors.

Tutorial: Investing Concepts

Preferreds - Some Good, Some Bad
In brief, preferred stock is something of a hybrid security that combines features of fixed income and common equity. Preferred stock is higher up in the credit structure than common equity and preferred shareholders are almost always entitled to dividends before common shareholders get any. On the other hand, preferred stock does not grant voting rights and investors often see significantly limited upside when the company thrives, as preferred stock dividends are usually locked in while common stock dividends can be whatever management can afford to pay. (For more, see A Primer On Preferred Stocks.)

Investors should also realize that their choices are quite a bit more limited when it comes to the companies and industries that issue preferred stock. Look at the rolls and investors will see a lot of banks and real estate companies, as well as some insurance and utility companies. By and large, industrial, health care and tech companies have no need to issue these securities.

What To Look For
Investors should always remember that these are not guaranteed securities and there is always a risk of loss. Beyond that, there are some other factors to consider before purchase. While many preferred stock dividends are eligible for favorable tax treatment, most trust preferred dividends are not. Investors should also be very aware as to whether they are buying cumulative preferred or not - cumulative means that if the company misses a dividend payment, that payment accumulates and must be paid in the future.

It is also worth mentioning that preferred stock can underperform as rates rise, though some preferred shares offer a variable rate that can move up in conjunction with higher rates. Last and not least, investors should be paying attention to any call provisions - a right that allows the company to repurchase the preferred shares at a predetermined price. Nothing is quite so frustrating as buying the "perfect" preferred stock and then seeing it called away.

A Few Ideas
U.S. Bancorp (NYSE:USB) has some interesting preferreds out there. One is a floating rate non-cumulative issue that goes by the USB-PH ticker. This security pays the higher of 3.5% or LIBOR plus 0.6%. Although this issue is callable in one week at a price of $25 per share, the current price of $22.65 (and the relatively low cost to USB) suggest a call is not expected.

TCF Financial (NYSE:TCB) has a pretty eye-popping trust preferred that trades with the ticker TCB-PA. This security is not callable until August of 2013 and the original coupon rate was 10.75% and it presently trades with a yield of 10.4%. This security is cumulative, but the company can defer payments for up to 10 years without technically defaulting. It is not eligible for favorable tax treatment. Given the coupon rate, it seems like a pretty good bet that this one will get called, but that still cannot happen for more than two years.

Investors should note that TCF Financial has issued common stock and received Federal Reserve approval to redeem these trust preferred securities. It is unclear though whether the company can declare that there has been a "capital treatment event" that would allow them to redeem the securities by the end of May, 2011

U.S. Bancorp and TCF are just two examples. Many other banks, including Bank of America (NYSE:BAC), Citigroup (NYSE:C), M&T Bank (NYSE:MTB), Goldman Sachs (NYSE:GS) and HSBC (NYSE:HBC) all have preferred stocks and/or trust preferreds that are worth a look.

Investors looking for a monthly payout could consider Tortoise Energy Capital Corp's (NYSE:TYY) Series B Mandatory Redeemable Preferred shares (TYY-PB). These shares pay dividends every month at an annual rate of 5%, and those dividends are eligible for the favorable tax treatment. These payments are cumulative, but the company can redeem these shares starting in March of 2012, with a slight premium (1%) that declines over time. Investors should also note that these shares are not very liquid.

Want to go even further into the exotic? Consider a STRATS, a Structured Repackaged Asset-Backed Trust Security. These securities are a little like ETFs or ADRs in the sense that the originator buys an asset, establishes a trust and then issues securities that allow investors to benefit from the performance of that underlying asset.

Consider the STRATS for Wal-Mart (NYSE:WMT) trading under the ticker GJO. These shares basically represent an interest in 7.55% notes issued by Wal-Mart due on February 15, 2030. Holders of this STRATS get a monthly payout (not eligible for favorable taxation) that is based upon the 3-month LIBOR rate plus 0.50%, with a maximum rate of 7.5%. These securities mature and go away when the note goes away, but could be redeemed early if there are problems with the underlying issue (the Wal-Mart note). Investors should realize that these shares are not especially liquid and currently yield 1.07%.

The Bottom Line
Preferred shares are not "free money," so investors need to realize that higher yields come at some price - be that less liquidity, less security, callability, or what have you. What's more, preferred shareholders are really on their own in many respects - the amount of research coverage and information out there is scant when compared to common stocks. That said, for investors willing to reach a little further for better returns, preferred stock may indeed be a preferred option. (For further reading, check out Stock Basics: Different Types Of Stocks.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis,risk free!

comments powered by Disqus
Related Analysis
  1. Handicapping the Q3 Earnings Season - Earnings Trends
    Stock Analysis

    Handicapping the Q3 Earnings Season - Earnings Trends

  2. Still More Gains Ahead For Semiconductor Makers
    Stock Analysis

    Still More Gains Ahead For Semiconductor Makers

  3. The Last Time This Happened, a 'Hated' Sector Rose 196%
    Investing

    The Last Time This Happened, a 'Hated' Sector Rose 196%

  4. JPMorgan Chase & Co., Other Financial Stocks Strong During Market Retreat
    Stock Analysis

    JPMorgan Chase & Co., Other Financial Stocks Strong During Market Retreat

  5. Q2 Earnings Season in Rearview Mirror - Earnings Trends
    Stock Analysis

    Q2 Earnings Season in Rearview Mirror - Earnings Trends

Trading Center