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