Preferred Stock Can Exceed 7 Percent
By Bob Moeller
WEAC Member Benefits
January 2003
Financial
Planning Seminars
Achieving
Financial Independence
This article is one of a series dealing with what I call
stable investments, including bonds, preferred stocks, and CDs. Last month,
I gave examples of investment-grade bonds paying 7.65%, 8%, and 9.85%
with maturities of less than 10 years. This month, we look at preferred
stock.
Preferred stock is generally rated similarly to bonds. Those
rated AAA, AA, A, and BBB, along with +’s and –’s are considered
investment grade. You should limit yourself to investment grade.
Preferred stock is much more difficult to get information
on, but the returns can be higher than bonds. Preferred stock terms are
also much more varied. One key is to find a reasonably priced broker who
can tell you the ratings, call dates, and yields.
Preferreds rank between bonds and common stock in terms
of your claim on the assets of a company if it goes bankrupt.
Preferred stock owners get a dividend, and if the company
doesn’t pay you a dividend it “owes” you the dividend (cumulative).
You must be fully paid up to date before the common stockholders can get
any dividends. So you have some preference over common stockholders. Companies
issue preferreds for various reasons, including:
- Most preferreds never mature, or mature many years later.
- If the company doesn’t pay a preferred dividend, the holders
have no real legal rights to demand property, etc.
- If corporations own another company’s preferred stock, they
often avoid a lot of taxation on the dividends they receive from the
other company. Thus, the issuing company may be able to issue preferreds
with a lower interest cost.
Let’s look at an example. Merrill Lynch Inc. has a preferred F issue,
which trades on the New York Stock Exchange and pays 7.28% of $25 or $1.82
as a dividend. The price on November 26, 2002, was $25.67 for an immediate
yield of 7.1%. The issue is rated Aa3/A. However, Merrill Lynch can call
this issue in at $25 anytime after September 30, 2008. That means that
if they call it in, you will get $25 when you paid $25.67. So you lose
67 cents in about six years. Roughly that’s 11 cents per year off
your $1.82 dividend, so your real yield is closer to $1.71 / $25.34 (your
average investment over six years), or about 6.7%. An exact calculation
of “yield to call” should be done by your broker unless you
are willing to settle for your own calculation similar to that above.
Merrill Lynch does not have to call this issue in and will never call
it in until interest rates for their new issues are less than 7.28%. In
other words, if interest rates go down enough that Merrill tires of paying
you 7.28%, they will call it in. If interest rates go up, they will be
happy to keep paying you 7.28%. This is the major problem with preferreds.
While they may pay a very good dividend rate, you have no time when you
are assured of getting your principal back. (Some preferreds do have maturity
dates, usually long in the future). Of course, you can easily sell your
stock any time.
How can preferreds fit into your investments? I have found that with
careful selection you can generate a very good overall dividend return
without undue risk. Just glancing at the preferred list in the Wall Street
Journal reveals yields readily available in the 6.5% to 7.5% range, or
even higher if you want to take the time to research issues. So, you can
add preferreds to bonds in terms of alternatives to low-income investments.
But it is important that you work with a knowledgeable broker.
Finally, there are a few mutual funds involved in selecting preferred
stocks, in particular some “closed end” funds listed on the
NYSE. They do all the selection for you, but in return you pay a management
fee typically of 1% to 2%. This, of course, cuts your net yield. Sample
symbols you might want to look up include PDF, PPF, JTP, and PFD. Request
information from the fund and understand their holdings and fees before
investing.
There are no open-end mutual funds dealing only with preferreds. Vanguard
merged its preferred fund into the Vanguard Convertible Securities Fund
a couple of years ago, and it has 80% of its funds in convertible bonds,
not preferreds. (But worth considering for a combination income and stock
market investment.)
Summary: Like bonds, preferreds reasonably rated paying over 7% are available,
but it takes some work.
Again, if you consider yourself a fairly conservative investor and want
to achieve diversification in your portfolio, follow this formula: Take
your age as a percent (plus or minus 10%) of what you put in more stable
“fixed” type investments such as bonds, preferreds, and CDs.
For example, if you are 45, consider a range of 35% to 55% for these types
of investments, or even more if you are quite conservative.
Posted December 20, 2002