How to Make Money from Inflation (WSJ)

WEEKEND INVESTOR
FEBRUARY 5, 2011.How to Profit From Inflation
The Scourge of Rising Prices Hasn't Hit Home Yet, but the Underlying Signs Point to Trouble Ahead. Here's What You Should Do Now.

By BEN LEVISOHN and JANE J. KIM

Inflation,long a sleeping giant, is finally awakening. And that could present problems—along with opportunities—for investors.

A quick glance at the overall inflation numbers might suggest there is little reason to worry. The most recent U.S. Consumer Price Index was up just 1.5% over the past year. Not only was that lower than the historical average of about 3%, but it was uncomfortably low for Federal Reserve Chairman Ben Bernanke, who prefers to see inflation at about 2%.

What to Do Now
Sell
Cash and Bonds: Treasurys, long-term bonds
Stocks: Financials, utilities and consumer staples
Hard Assets: Gold, real estate

Buy
Cash and Bonds: Floating-rate funds, inflation-linked CDs
Stocks: Small-company value stocks
Hard Assets: Commodities, real-return funds

Yet it is a much different situation overseas, particularly in the developing world. In South Korea, the CPI rose at a 4.1% clip in January from a year earlier, higher than the 3.8% estimate. In Brazil, analysts expect prices to rise 5.6% this year, exceeding the central-bank target of 4.5%. China, meanwhile, has been boosting interest rates and raising bank capital requirements to keep inflation, which rose to 4.6% in December, in check.

"Emerging market economies are overheating," says Julia Coronado, chief economist for North America at BNP Paribas in New York. "They need to slow growth or inflation will become destabilizing."

Even some developed economies are seeing rising prices. Inflation in the U.K. surged to 3.7% in December, while the euro zone's rate climbed to 2.4% in January, the fastest rise since 2008.

Much of the uptick has been driven by commodity prices. During the past six months, oil has jumped 9%, copper has gained 36% and silver has shot up 56%. Agricultural products have soared as well: Cotton, wheat and soybeans have risen 100%, 24% and 42%, respectively. That's a problem because rising input prices "work their way down the food chain to CPI," says Alan Ruskin, global head of G-10 foreign-exchange strategy at Deutsche Bank.

Of course, the main inflation driver is usually wages—and that isn't a factor in the U.S., where high unemployment has kept a lid on pay for three years.

Yet there isn't a historical blueprint for the inflation scenario that seems to be unfolding now. Not only has the global economy changed drastically since the last big inflationary run during the 1970s, but the lingering effects of the recent debt crisis remain a wild card.

For investors, that means traditional inflation busters such as real estate and gold might not work as expected, while other strategies might perform better.

So how should you position your portfolio? The best approach, say advisers, is to tweak asset allocations rather than overhaul them. That involves dialing back on some kinds of bonds, stocks and commodities and increasing holdings of others. Here's a guide:

What to Sell
• Bonds. The price of a bond moves in the opposite direction of its yield. When inflation kicks up, interest rates usually move higher, pressuring bond prices. Even buy-and-hold investors get hurt, because higher inflation erodes the real value of the interest payments you receive and the principal you get back when the bond matures.

'There is no historical blueprint for the inflation scenario that seems to be unfolding now.'.The drop is usually most extreme in longer-dated bonds, because low yields are locked in for a longer period of time. So inflation-wary investors should shorten the maturities of their bonds, say advisers.

The safest bonds, especially Treasurys, are usually hardest hit, because those are the most influenced by changes in rates—unlike corporate bonds, whose prices also move based on credit quality. From September 1986 through September 1987, for example, as inflation moved higher, Treasurys dropped 1.2%.

It might even make sense to dial back on Treasury inflation-protected securities, whose principal and interest payments grow alongside the CPI. That's because investors already have flooded into TIPS, driving up prices and driving down the real, inflation-adjusted yields. A typical 10-year TIPS, for example, yields just 1.1% after inflation, compared with an average of more than 2% in recent years.

With so little cushion, long-term TIPS carry a higher risk of loss for investors who are forced to sell before the bonds mature. "Even if inflation is rising, you can still lose money," says Joseph Shatz, interest-rate strategist at Bank of America Merrill Lynch.

• Hard assets. Real estate may be a classic inflation hedge, but it seems likely to disappoint investors this time around. Even though rising inflation should put upward pressure on home prices, the twin forces of record-high foreclosures and consumers reducing their debt loads are expected to mute price gains for several years, says Milton Ezrati, senior economist at asset manager Lord Abbett. That's a far cry from the 1970s, when the median home price rose 43%, according to U.S. Census data.

Gold is another traditional inflation hedge that might be less effective now. With prices already having more than quadrupled over the past nine years, many strategists see substantial inflation already factored into the price.

Hot Commodities
Commodities that are more closely tied to industrial or food production seem better positioned now than gold, say advisers.

Historically, gold has moved with the money supply. During the last 30 years, the correlation has been about 69%, according to FactSet data. (A correlation of 100% means two indexes move in lockstep all the time; a correlation of minus-100% means they move in perfect opposition.) Based on the money supply alone, gold is priced 25% above where it should be, says Russ Koesterich, chief investment strategist at BlackRock Inc.'s iShares.

• Stocks. Equities can be a decent hedge against creeping inflation, because companies are better able to pass off costs to customers. But when input costs suddenly jump, profit margins take a hit.

At the same time, the higher interest rates that accompany inflation prompt investors to demand more profits for each dollar invested. As a result, price/earnings ratios tend to shrivel. Over the past 55 years, the average trailing P/E ratio of a stock in the Standard & Poor's 500-stock index has fallen to 16.95 during periods with inflation running between 3% and 5%, from 19.24 during periods with inflation of 1% to 3%, the most common inflation range since 1955, Mr. Koesterich says.

Sectors that are sensitive to interest rates, including financials, utility stocks and consumer staples, are especially vulnerable, say advisers.

What to Buy
• Cash and bank products. Money-market mutual funds are more attractive in inflationary environments because the funds invest in short-term securities that mature every 30 to 40 days, and therefore can pass through higher rates quickly. In an extreme example, money funds posted yields over 15% during the inflation-ravaged 1970s and early 1980s, says Pete Crane of Crane Data, which tracks the funds.

A growing number of inflation-linked savings products are cropping up as well. Incapital LLC, a Chicago investment bank, says it has seen a pickup recently in issuances of certificates of deposit designed for a rising-rate environment. Savers, for example, can invest in a 12-year CD whose rate starts at 3% then gradually steps up to 4.25% starting in 2015, and peaks at 5.5% starting at 2019 until the CD's maturity in 2023.

A caveat: If inflation eases and rates fall, investors could get burned, since the issuer may call the CDs and investors would lose out on the higher rates at maturity.

• Bonds. One way to reduce the impact of rising inflation on bond holdings is to build a bond ladder—buying bonds that mature in, say, two, four, six, eight and 10 years. As the shorter-term bonds mature, investors can reinvest the proceeds into longer-term bonds at higher rates.

"A bond ladder is best for someone who doesn't mind holding them for up to 10 years," says Jeff Feldman, an adviser in Rochester, N.Y.

Highly cautious investors might prefer the I Bond, a U.S. savings bond that earns interest based on a twice-yearly CPI adjustment. Although the current yield on I Bonds is only 0.74%, that yield is likely to move higher on May 1, the next time the rate is adjusted. I Bonds aren't as volatile as TIPS and appeal to conservative, buy-and-hold investors. The interest may also be tax-free for some families for education expenses.

More adventurous types might consider the inflation-protected government debt of other nations, which carry higher yields along with greater risks. The SPDR DB International Government Inflation-Protected Bond Fund is an international inflation-protected bond exchange-traded fund designed to do well if inflation in overseas countries moves higher. The fund returned about 6.8% in 2010 and 18.5% in 2009, according to Morningstar Inc.

• Bank-loan funds. Another way to exploit rising inflation is through mutual funds that buy adjustable-rate bank loans, many of which are used to finance leveraged corporate buyouts. So-called floating-rate funds are structured so that if interest rates rise, they collect more money. During periods of rising rates, floating-rate funds usually outperform other bond-fund categories. In 2003, for example, as investors anticipated higher interest rates and a stronger economy, bank-loan funds gained 10.4% while short-term bond funds gained 2.5%.

Now, amid expectations of rising inflation, investors are once again flocking to these funds, pouring in about $7.6 billion into loan funds in the fourth quarter of last year, according to Lipper Inc.—more than double the previous quarterly record set in 2007. The pace has accelerated this year, with investors putting in about $3.4 billion thus far.

After gaining almost 10% last year, the funds shouldn't be counted on for much price appreciation, says Craig Russ, who co-manages $22.7 billion of floating-rate investments across three floating-rate funds and other accounts at Eaton Vance Corp., including the Eaton Vance Floating Rate Fund. But the funds generate plenty of income, yielding about 4% to 5% now, according to Morningstar.

Price Increases
From Aug. 2, 2010 through Feb. 4, 2011:

Cotton: +100%
Silver: +50%
Soybeans: + 42%
Copper: +36%
Wheat: +24%
.


Be warned: Floating-rate funds can get creamed when investors fear the underlying loans are too risky. In 2008, for example, bank-loan funds lost 29.7%, although they zoomed 41.8% in 2009, according to Morningstar. What's more, banks are beginning to make riskier "covenant-light" loans that carry fewer stipulations for corporate borrowers—a sign of frothier trends in the market.

Given the potential for volatility, floating-rate funds are best viewed as a complement to—not a replacement for—investors' core bond holdings. Among Morningstar's picks in this category is the Fidelity Floating Rate High-Income Fund, among the more conservative in the category.

• Commodities. Materials that are more closely tied to industrial or food production seem better positioned now than gold, say advisers. The trick is to find the best investment vehicle.

The easiest way for small investors to gain exposure to most commodities is through exchange-traded funds, many of which use futures contracts. But such funds can be dangerous because they often face "contango"—when the price for a future delivery is higher than the current price. The result: The ETFs lose money as they buy new contracts, even when prices are rising.

The losses can be extreme. In 2009, for instance, while the price of natural gas rose 3.4%, the United States Natural Gas Fund lost 56.5% as a result of rolling over futures contracts.

Some firms have rolled out ETFs that aim to address the problem. One of Morningstar's picks is the U.S. Commodity Index Fund, run by U.S. Commodity Funds LLC. The portfolio buys the seven commodities that are most "backwardated"—the opposite of "contango," so rolling contracts should result in a profit—along with the seven commodities with the most price momentum.

"USCI provides an outlet for investors who want broad commodities exposure but don't want to worry about the daily dynamics," says Tim Strauts, a Morningstar analyst.

Other funds play inflation by holding many different assets to protect against rising prices no matter where they show up. The IQ Real Return ETF, launched in 2009 by IndexIQ, aims to provide a return equal to the CPI plus 2% to 3% over a two- to three-year period. To get there, it invests across a dozen or so inflation-sensitive assets—including currencies and commodities.

• Stocks. One corner of the market tends to do better when prices rise suddenly: small-company value stocks. "Because value and small stocks tend to be fairly highly [indebted] companies, inflation reduces their liabilities," says William Bernstein of Efficient Frontier Advisors LLC, an investment-advisory firm in Eastford, Conn.

From January 1965 through December 1980, for example, inflation averaged 6.6% a year. The Ibbotson Small-Cap Value Index posted average annual returns of 14.4%, according to Morningstar's Ibbotson Associates, double the S&P 500's 7.1% gain.

Morningstar's picks in the small-cap value fund category include Allianz NFJ Small Cap Value, Diamond Hill Small Cap, Perkins Small Cap Value and Schneider Small Cap Value. Just be warned: Small value stocks have had a good run recently, returning 134%, on average, since March 6, 2009.

In the end, the particulars of any inflation-fighting plan may not be as important as developing a plan in the first place.

"The real problem you run into with any kind of inflation hedges," says Jay Hutchins, a financial adviser in Lebanon, N.H., "is that if you don't already have them when inflation is around the corner, you've missed the boat."

Write to Ben Levisohn at ben.levisohn@wsj.com and Jane J. Kim at jane.kim@wsj.com

Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

Rare Earth Elements: Where They Are, Where They Go (New York Times)

February 6, 2011
Many Want Rare Earths, but Few Are Mining Them

By KARL RUSSELL
The New York Times

"RARE earth” is a historical misnomer. Elements that fall under this label were identified mostly in the 18th and 19th centuries, when the word “earths” was used to describe a group of geological materials. At the time, a subset of these was thought to be uncommon.

In fact, rare earths are relatively abundant. But they are very hard to extract, and processing them can cause environmental damage. The process involves toxic acids, and rare earths are often found in deposits containing the radioactive elements uranium and thorium.

The first color television included rare earths. Recently, demand for them has become more acute, as they have been used to make an array of high-tech products including smartphones, hybrid cars, flat-panel televisions, wind turbines and military weapons.

China has almost total dominance of the rare earth market, and concerned businesses and governments are pushing for expanded production in other countries. But it can take years to increase mining in Western nations, where there are many environmental and regulatory hurdles.

College Loans - Tips for FAFSA (Fidelity)

5 tips for tackling FAFSA
BY Mark McLaughlin,
Fidelity Interactive Content Services — 02/08/11

Virtually anyone who wants college aid must fill out a form known as FAFSA. Here’s the lowdown on the 136-question document.
Now that your high school senior has put the finishing touches on her college admissions essays, it’s your turn to grapple with an application deadline.

Welcome to the world of FAFSA.

The federal government’s Free Application for Federal Student Aid, also known as FAFSA, is a prerequisite for undergrads to qualify for a host of federal aid programs, from grants to student loans. While individual colleges set their own deadlines for filing FAFSA, the first major due date is approaching: Feb. 15, for students applying to schools in Connecticut.


“We encourage everyone to apply through FAFSA,” says Tom Graf, executive director of the Massachusetts Education Financing Authority, a nonprofit state agency that focuses on college financing for families.

In recent years the sluggish economy and stubbornly high unemployment have sent the number of FAFSA applications soaring. For the first four weeks of this year, applications were up 40% from the same period last year, according to the federal Department of Education, which administers the FAFSA program.

A lot is at stake. For the 2009-2010 school year, the average undergrad received about $11,460 in loans and grants from federal, state and private sources, according to DOE. And while the FAFSA includes 136 questions on everything from student and family finances to your child’s academic background and planned course of study, veterans of the process say with a little preparation, it’s manageable.

Filing FAFSA “may seem daunting but it is pretty straightforward,’’ says Carol Meerschaert, a Fairfield, N.J., mother of two college graduates and a high school senior headed to college in the fall. Still, “This isn’t a late night, too-tired-to-think undertaking,” she says.

To make the process more efficient, and less painful, here are five things you should know when completing FAFSA with your college-bound child.

1. File even if you don’t expect aid
Beyond federal financial aid, the FAFSA also is used by many states, colleges and universities for their own assistance programs. Some colleges require it for students on athletic scholarships.

The perception that no aid will be available is perhaps the biggest reason families skip the FAFSA. A 2006 study by the American Council on Education found that 1.5 million college students who could have qualified for Pell grants in 2003-2004 failed to apply. More recently, former Secretary of Education Margaret Spellings said some 8 million students eligible for aid don’t even send in an application.

“Why turn any money away? Why leave any money on the table?” says Mary Fallon, a spokeswoman for Student Financial Aid Services Inc., a private firm that advises families on maximizing financial aid and runs the website www.fafsa.com. (It’s not affiliated with the federal Education Department).

Returning students should remember to refile FAFSA each year they’re enrolled in college. In addition to completing FAFSA, students applying to private colleges should also fill out the College Board’s CSS Financial Aid Profile to qualify for non-federal financial aid.

2. Don’t wait to file your taxes first
Many state and individual college deadlines fall before the federal tax deadline. Kentucky, Illinois, Oregon, South Carolina and Tennessee have started awarding aid, and most aid packages will be finalized before this year’s April 18 tax filing deadline, according to Mark Kantrowitz, an expert on college financial aid.

The FAFSA worksheet available at www.fafsa.ed.gov contains a summary of filing deadlines by state.

You can complete FAFSA using estimated tax information. Just choose the “Will File” option on the application form, and then estimate your income. You must remember to make any necessary adjustments once your taxes are complete; there is no penalty for doing so.

“Don’t wait until the last few days to file your forms,” says certified college planning specialist Manuel Fabriquer of CollegePlanning ABC. If you do, you’ll most probably run into technical difficulties because so many people will be filing then.

Filing the FAFSA
Applicants can file the form online or download a paper version at
www.fafsa.ed.gov, the website run by the Federal Student Aid office of the
Department of Education. Filing electronically is recommended because it’s
faster and you can correct errors. The site has tips to help
you file. Here are some to get you started:
Get a PIN: Apply for a Department of Education personal
identification number right away atwww.pin.ed.gov as they can take up
to five business days to process. Both parent and student need a
PIN, which allows you to sign FAFSA electronically and make
corrections.
Organize your paperwork: The FAFSA on the Web
worksheet highlights the main financial information you’ll need to include
on the application.
Predict potential aid:
The FAFSA4caster provides an estimate of your federal
financial aid eligibility. Studies have shown knowing your
potential award ahead of time increases the chance
you’ll apply.
Get help: The Federal Student Aid office can
answer questions online or over the phone. Contact
information is available on the website.
Save time: Returning college students can
choose to fill out a Renewal FAFSA that
pre-fills most of the information from the
previous year.
3. Highlight unusual circumstances
The FAFSA for the 2011-2012 school year is based on financial information from 2010 but it’s important to explain major changes, if any, in your family’s financial situation.

If you’ve suffered a job loss, answer yes to the Disclocated Worker question on the form. The question doesn’t allow for an explanation so follow up with a more detailed letter to the financial aid offices at your child’s target schools.

You should also explain other financial hardships such as reduced income, major medical bills and anything else that dramatically affects your income.

If you want to appeal an aid decision, remember that at most schools no appeals will be heard until the school has received a completed FAFSA — another reason to complete the application as soon as possible.

4. Your FAFSA could be flagged
After your FAFSA has been processed, you’ll receive a Student Aid Report that includes an Expected Family Contribution, expressed in dollars. The EFC is used by schools to help calculate how much federal aid your child may receive.

Don’t panic if your report includes an asterisk next to the EFC. This means the DOE is requiring documentation of your financial information. Its automated processing system selects up to 30% of each college’s applications for verification. This is not a formal audit but is required by the DOE.

Kantrowitz recommends parents submit the documents requested by the college as soon as possible because federal rules prevent the distribution of aid until verification is complete.

Your child’s Student Aid Report will not include an EFC if your application is incomplete, but it should explain what needs to be addressed. A common mistake is using dashes or leaving responses blank instead of entering zeros when asked for dollar amounts, explains Barbara Cooke, a college counselor in Kansas City, Mo.

5. FAFSA has its quirks
Federal financial aid calculations do not always follow the same guidelines as the tax code. This has led to confusion for students of divorced parents as well as those seeking to claim independence. Some things that often trip up parents:

For divorced parents, financial aid is based on the income of the parent the child lived with the most over the preceding 12 months. If that custodial parent has remarried, the income of the stepparent also figures into the EFC. The income of the noncustodial parent does not count.
Just because a student is living away from home and financially supporting herself, that does not mean she is considered independent, according to FAFSA. There are exceptions, if a student is married or a parent, for example, but few applicants will be successful filing independently of their parents, financial aid experts say.
The DOE’s Federal Student Aid office and state financial aid groups offer free assistance with FAFSA, or you can hire a private counselor to help. To sift through the wide variety of private counseling services available, use the search by state function on the National Institute of Certified College Planners website (http://www.niccp.com/search.asp).

“[FAFSA] is really a beginning to find out your ability to pay,’’ says MEFA’s Graf. “It’s the gateway to many of the financial aid options that are available.”

Floating Rate Notes to Cope with Rising Interest Rates (Wall St Journal)

Floating-Rate Notes Resurface As Economy Grows Again

By Katy Burne of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--Corporate borrowers are switching up the composition of their debt sales, throwing more floating-rate notes into the mix to entice investors who believe interest rates may be about to rise sooner and faster than expected.

Nearly $26 billion, or 23%, of the investment-grade bonds marketed in the U.S. so far this year have had floating rates, according to data provider Dealogic, making it the busiest January for so-called floaters since 2007. That compares with $57.4 billion, or 7% of the supply, for all of 2010.

Bankers expect to see more floaters this year for two reasons: Issuers are suddenly comfortable selling them; and investors are eager to buy them to position their portfolios for a potential rise in rates.

"People have had the view for the last year, or year and a half, that short-term rates aren't going higher any time soon, and that is not an environment where you think you can make money on floating-rate debt," said Jim Merli, head of debt origination and syndicate at Nomura Holding Americas Inc.

"Now that is starting to change," Merli added, "because there is stronger economic data, and other central banks outside the U.S. are making noises about raising short-term rates."

Data over the last few months have been supportive of a more bullish outlook on the economy, with more job creation, a rising stock market, and strong corporate earnings over the past two weeks.

"While there are certainly headwinds like unemployment and weak wage gains, the data is far more balanced and the growth camp seems to have the scales tipping in its favor," said David Ader, head of government bond strategy at broker-dealer CRT Capital Group.

To be sure, floating-rate deals account for only a fraction of the market share they had in the middle of the last decade, and the volume outstanding has fallen by 40% since end of 2007 to $428.9 billion now. But issuers are warming up to them again.

Financial institutions tend to be the biggest issuers of floating-rate debt, to bring their funding in line with assets such as floating-rate loans. Financial firms, including insurers as well as banks, have accounted for 63% of the U.S. high-grade issuance in dollar volume so far this year, the highest percentage for any January since at least 1995, when Dealogic started keeping records.

About 57% of that total was from banks, although units of non-financials like brewer Anheuser-Busch InBev SA/NV and energy giant Total SA have recently issued floaters, too.

AB In-Bev's strategy of pairing fixed- with floating-rate debt was "a function of the expected long-term recovery of the economy versus the short-term opportunity to benefit from historically low rates," said Scott Gray, director of global funding and financial markets at the company in New York.

Johnson Controls Inc. was in the market Tuesday with $350 million of three-year floating-rate notes as part of a $1.6 billion deal.

Heavy issuance by foreign banks has also contributed to the rise in these securities. They borrow in the U.S. because investor appetite is stronger here than in their domestic markets. January saw the largest volume of these so-called Yankee deals--dollar-denominated bonds sold by foreign firms in the U.S.--than any other month on record.

"Since the euro markets were less friendly to new issuance, floater deals that would normally have come as euro bonds were instead dollar issues," said Guy LeBas, chief fixed income strategist at Janney Capital Markets in Philadelphia.

Most of the floating-rate debt sold this year has been clustered around two- and three-year maturities, as was the case in 2009. Last year's issuance was more evenly spread between three-, five- and 10-year floaters, helping to stem the pace at which maturing debt exceeded new supply.

There is about $32 billion of floating-rate, Federal Deposit Insurance Corporation-insured bonds under the government's Temporary Liquidity Guarantee Program maturing this year, said LeBas, all of which needs to be refinanced--including $5 billion in the first quarter.

"Given that all the government-guaranteed debt from 2009 is maturing in 2011, banks will be able to issue short-term floaters beyond that maturity cliff," said Justin D'Ercole, head of Americas investment-grade syndicate at Barclays Capital. "As opposed to the last two years, when it would have had the effect of adding to their massive wall of maturities, it now fits into their debt-distribution profile."

LeBas said while there is marginally greater demand for floaters based on concerns about rising rates, investors are better off buying short-dated, fixed-rate debt. If rates rise and the income on the bond resets progressively higher, an investor would win out over time only if rates rise enough to offset the lower income in the early going.

"Rates would have to rise quite rapidly for it to make sense to accept such a low initial coupon," he said.

Last Thursday, ABN AMRO Bank N.V. sold $2 billion of fixed- and floating-rate bonds, with the $1 billion of floaters pricing at 1.77 percentage points over Libor, equivalent to a coupon of 2.07%, and the $1 billion of fixed-rate notes pricing with a coupon of 3%.

"Investors are using these floaters to shorten duration and express their view on the pace of future Fed tightening," said Michael Hyman, head of investment-grade credit at ING Investment Management, who participated in the ABN AMRO deal.

-By Katy Burne, Dow Jones Newswires; 212-416-3084; katy.burne@dowjones.com

Preferred Stock (Wall St Journal)

THE INTELLIGENT INVESTOR
FEBRUARY 5, 2011.
Preferred Stock: Are Those Juicy Yields Worth the Extra Risk?
By JASON ZWEIG..

As the Federal Reserve's low-interest-rate policy has turned the world of income investing into a howling wilderness, one oasis seems to remain: preferred stocks. With yields averaging nearly 7%, preferred shares seem to offer higher income at lower risk than either conventional stocks or the bonds that feel overpriced to many investors.

And the preferred oasis is one hot destination. The iShares S&P U.S. Preferred Stock Index Fund was the fourth-most-popular exchange-traded fund in 2010, returning 14% and doubling in size to more than $6 billion. Last month, it took in another $200 million. Fidelity Investments, Charles Schwab and TD Ameritrade all report rising interest in preferred stock among their brokerage clients.

It isn't hard to fathom why preferred shares might sound appealing. Ranking between common stock and bonds in a company's capital structure, preferred shares have the first claim on dividends. And those dividend yields may be "qualified," or taxable at lower rates than bond income.

But preferred stocks aren't low-risk. Unlike the interest on bonds, the dividends on preferred (as with common) stock can be shut off at will.

During the financial crisis, U.S. regulators suspended dividends on preferred shares issued by such giants as Fannie Mae and Freddie Mac. Many other banks stopped paying their preferred dividends. The Standard & Poor's U.S. preferred-stock index fell roughly 26% in September 2008, three times worse than "junk" bonds. Even in a bull market, preferred stocks are about 10% riskier than junk bonds, reckons economist Eddie O'Neal of Securities Litigation & Consulting Group in Fairfax, Va.

Preferred stock also can be "called away" if the issuer wants to retire it. That caught Stan Aten, a printing-company employee in Dallas, by surprise last year when some of his preferred shares of real-estate operator Public Storage, for which he had paid $25.74, were redeemed by the company at $24.50. Mr. Aten, who had bought a few months earlier, lost about $135. He still buys preferreds, but more carefully. "I should have read the prospectus and realized they had the right to do that," he says.

Also, "preferred stock" and "financial stock" are virtually synonymous. Fully 84% of the assets of the iShares preferred ETF are in financial firms, including Barclays, Bank of America and MetLife. Banks get special regulatory treatment on their preferred shares that other companies don't; outside of utilities, only 6% of nonfinancial firms have preferred stock, according to Standard & Poor's index analyst Howard Silverblatt.

"If you work in the financial sector you should definitely not buy a preferred fund," says Mariana Bush, a fund analyst at Wells Fargo Securities. With your career riding on the health of that financial industry, you shouldn't put even more money in the same place.

Finally, the income on preferred shares can be taxed either at the 15% rate that applies to dividends—or at your ordinary income rate, which can range up to 35%.

Generally, for the income to be taxable at the lower rate, a fund must own the preferred shares for at least 61 out of the 121 days on either side of the dividend date. That could get tricky for a fund whose asset base changes quickly, says independent tax expert Robert Willens. If a growing fund had to buy a lot of preferred shares quickly, or a shrinking fund had to sell them in haste, it wouldn't be able to keep them all for the minimum holding period. That, in turn, could subject investors to the higher tax rate on those dividends.

"Even if you are able to hold for the requisite period, you could be out of luck," Mr. Willens says. "That's because so much is dependent on the actions of other people over whom you have no control"—those who happen to be buying or selling the fund.

The iShares preferred fund has grown steadily and gradually over the past year, rather than in sudden bursts. Portfolio manager Greg Savage agrees that rapid inflows or outflows "can potentially affect the mix" of how the fund's income would be taxed. He adds that "flow impact has been negligible" so far. About 40% of the fund's dividend stream qualified for the lower tax rate in 2010, the same as the year before and the same as the underlying index.

These rules also apply to individuals buying preferred stock directly; sell too soon and you could double your tax rate on your latest dividends.

Preferred investors are pursuing long-term yield, says Rob Williams, director of income planning at the Schwab Center for Financial Research. "Unfortunately, a lot of investors also have short memories."

— twitter.com/jasonzweigwsj
Write to Jason Zweig at intelligentinvestor@wsj.com