Time For Preferred Stocks?

With the market looking weak, and banks paying next to nothing in terms of interest, you should consider shifting some of your cash to preferred stocks.

You can find many preferreds paying dividends equating to 5% to 8% annual yields. Dividend yields (annual dividends divided by your cost) are analogous to bank account interest rates. However, your principal is not insured, so investing in preferreds is riskier than keeping your money in the bank.

Nevertheless, if you apply a little common sense when you make your selections, preferreds are a relative safe bet in this market. Here’s what you need to know.

About Preferreds

Although you buy and sell them the same as stocks, preferreds are more like bonds. That is, they represent debt, not ownership. You buy them for steady income, not for capital gains. One word of caution, unlike bonds, a firm may suspend payment of its preferred dividends without filing for bankruptcy. Thus, it’s important to pick preferreds issued by companies with strong balance sheets.

Most firms issue preferreds at $25 per share, although some go for $50 or $100. The issuer sets an annual dividend (usually paid quarterly), which typically remains fixed. The “coupon rate” is the dividend yield based on the issue price. In this market, coupon rates vary from 4.5% to 8.5%, depending on the perceived financial strength of the issuing firm.

An issuing firm can have its preferreds credit-rated by agencies such as Moody’s or Standard & Poor’s. The rating agencies use combinations of letters, numbers, and plus or minus signs such as AAA, BA1 or B-. Details vary between agencies, but any rating starting with A, and three letter ratings starting with B, signal investment quality. If you want to be on the safe side, stick with preferreds rated investment quality. However, since firms must pay for the ratings, many issuers don’t have their preferreds rated. Thus, an unrated preferred doesn’t necessarily mean that it’s not investment grade.

Just like stocks, preferred share prices vary with supply and demand. Currently, demand is high and most are trading above their issue price. For instance, $25.00 preferreds are typically trading in the $25.50 to $27.00 range.

Most preferreds are “callable” meaning that the issuer has the right to call (redeem) them at the “call price,” which is usually the same as the issue price. The shares can be called at any time after the “call date,” which is typically five years after the issue date.

Yield to Call

When considering a preferred selling for more than the call price, that premium reduces your overall return. “Yield-to-Call,” which is the annualized return that you would receive if a preferred were called on its call date is the number that you need to know. You can use MoneyChimp (www.moneychimp.com ) to calculate yield-to-call.

Once there, select “Calculator” and then “Bond Yield.” It’s set up to calculate “yield-to-maturity” for bonds, but you can use it for yield-to-call by entering your preferred’s “years-to-call” in the “yield-to-maturity” entry box. When you get your answer, interpret “yield to maturity” as “yield to call.”

For practice, do the calculation for a preferred with a 6.5% coupon rate trading at $26.50, and with 4.5 years to call. You should get 5.1% for yield to call.

What should you require for yield to call? That depends on your needs. My rule of thumb is a minimum 4% for investment grade preferreds and 5%t for unrated preferreds. Since many preferreds are not called until long after the call date, your actual return will probably exceed the calculated number.

Checking Out Preferreds

You can use Quantum Online (www.quantumonline.com ), a free site, to find basic information about any preferred. You can also use Quantum’s Income Securities Screening Form (Income Tables menu) to find preferreds of interest to you.

To evaluate preferreds you’ll need two items not shown on Quantum Online, the current trading price and average daily trading volume. You can find those in the Investing section of MSN Money (money.msn.com). While you need the price to calculate yield to call, average daily trading volumes are also important. Some preferreds trade at very low volumes, making it difficult to buy or sell at reasonable prices. Look for preferreds trading at least 5,000 shares daily, and higher is better.

As mentioned, the issuing company’s financial strength is important. If you don’t want to analyze balance sheets, as a rule of thumb, avoiding preferreds issued by firms whose common stocks are trading below $20 per share should keep you out of trouble.

Four Preferreds For Starters

Here are four preferreds that you could use to start your research.

Aspen Insurance Holdings (ticker AHL-B): issue price $25.00, recent price $26.80. Credit Rating BBB-, Call Date 7/1/17, Coupon Rate 7.25%, Yield to Call 5.2%.

Goldman Sachs Notes (GSF): issue price $25.00, recent price $26.46. Credit Rating A-, Call Date 11/1/15, Coupon Rate 6.125%, Yield to Call 4.0%.

Maiden Holdings (MHNB): issue price $25.00, recent price $26.44. Credit Rating BBB-, Call Date 3/27/17, Coupon Rate 8.0%, Yield to Call 6.3%.

Apollo Commercial Real Estate Finance (ARI-A): issue price $25.00, recent price $25.71.Credit Rating NA, Call Date 8/1/17, Coupon Rate 8.625%, Yield to Call 7.9%.

Preferreds ticker symbols are not standardized. The symbols I’ve listed can be used on Quantum Online, Microsoft Money and TDAmeritrade (www.tdameritrade.com ). When you’re ready to buy, use your broker’s symbol lookup function.

published 11/4/12