“Investors have always faced the same basic decision: equities or fixed income? In most cases, common stocks offer the strongest capital gains and growth potential. ... But ownership is a double-edged sword: If a company’s fundamental prospects deteriorate, the value of the shares can decline and, in the worst case scenario, the firm could go bankrupt, wiping out most or all of your investment.
“Bonds are often called ‘fixed income’ securities. That’s because a bond typically pays out a fixed percentage of its par value according to a regular annual, semi-annual or quarterly schedule. For a typical bond, the amount paid out to holders is fixed—if you buy an 8% bond with a par value of $1,000, you can count on receiving $80 per year, every year until the bond matures. At maturity, you would expect to receive the entire face value of the bond. Bonds are backed by the assets and credit of the company or government that issues them. ... While fixed income offers safety and security, there are real risks in the bond market as well. If inflation rises after you purchase a bond, it erodes the value of the fixed coupon payments you receive. ... And relative to stocks, one of the biggest risks is opportunity cost: When you buy a bond, the best outcome is that the issuer makes all its payments on time and pays back the face value at maturity. For plain vanilla bonds, the investor doesn’t have an opportunity to participate directly in improving growth prospects or business conditions as common shareholders would.
“But you can generate some of the high yields and safety of bonds while also maintaining some upside and growth potential inherent in common stocks. One often- overlooked market allows you to do just that: preferred stocks. Preferreds are hybrid securities that share some similarities with common stocks and some with bonds.
“Not all preferreds are the same. Some are more like bonds, offering high yields and guaranteed fixed payouts. Others are more equity-like, featuring participation in the appreciation of the underlying common stock or higher yields at the expense of less protection for your principle.
“The beauty of preferreds is their diversity: Investors willing to do their homework and examine the features of a particular preferred stock issue can uncover stocks that offer compelling combinations of yield, upside potential and safety. The salient features of every preferred stock can be found in their prospectus, issued before the preferred begins trading. Here’s a look at five key factors to watch when analyzing preferreds:
“Convertible Preferreds: Some preferred stocks allow the holder to convert their shares into common stock at some point in the future and at a predetermined price. This allows shareholders to participate directly in the appreciation potential of the firm issuing the preferred. Convertible preferreds typically offer lower yields than straight non-convertible preferreds because the option to convert into common stock makes them more attractive investments. In addition, convertible preferreds will tend to see more price volatility than straight preferred stock because their value depends in part on the value of the underlying common stock.
“Callability: If a preferred is callable, the issuer can redeem the shares at a pre-set price at some point in the future. For example, if a firm issues a preferred with a call price of $25 and a call date two years into the future, the company can buy back its preferreds for $25 per share two years later no matter what the price is. This is true even if the preferred is trading in the open market at a price greater than $25 at the time it’s called. It’s important to watch the call schedule for all preferreds you own, especially for those trading at a premium to their call price. You do not want to have your preferreds called away at an unfavorable price.
“Cumulative: In some cases, the issuer of a preferred share can temporarily delay paying dividends on the preferred. With a cumulative preferred, all skipped and current dividends must be paid in full before any other dividends are paid, such as dividends on common shares.
“Noncumulative preferreds are less common but allow the issuer to skip payments without making up those missed dividends.
“Credit Rating: Like bonds, most preferred shares are rated by credit agencies like Standard & Poor’s and Moody’s. Investors should never rely solely on credit ratings when assessing risks; the agencies have made plenty of bad calls when rating companies, governments and derivative investments over the past few years.
“But credit ratings can still offer a solid starting point for assessing risk. Also note that the rating on a particular preferred share will typically be less than for the same company’s bonds. The reason is that bondholders are paid before preferred shareholders who are, in turn, paid off before common stockholders receive any return on their investment.
“Seniority: A single company can have multiple bonds and preferred stocks trading at any point in time. Some of these preferreds may be senior to other issues, meaning that they’re paid first in the event of bankruptcy and default.
“And there’s another piece of good news for U.S.-based investors: Many foreign companies choose to list one or more preferred shares on the major U.S. exchanges to attract capital from U.S.-based investors. That means that you have your choice of several high-yield foreign preferreds offering different risk, growth and yield combination potential.
“With a yield over 9%, Santander Preferred E (STD-E), preferred stock issued by Spanish banking giant Santander (STD), is already a member of my ‘Ultra High-Yield’ Portfolio and is on my ‘Buy First’ List. And PowerShares Financial Preferred (PGF), also in my ‘Ultra High-Yield’ Portfolio, is an exchange-traded fund (ETF) that invests in a portfolio of preferreds issued by 30 major international financial institutions.”
Paul Tracy, High-Yield International, 5/27/11
