After a long absence, volatility returned to world financial markets in recent weeks.
That’s not a bad thing necessarily. It never hurts to be reminded that stocks and bonds are not cars on a one-way street.
The traffic often reverses – suddenly and without warning.
Many investors – especially income investors – are now wondering where they can earn a decent return with a lower level of risk.
One suggestion: preferred stocks.
Preferreds are often called hybrid securities. They have the properties of both stocks and bonds.
Unlike common stocks, they generally carry no voting rights. But the dividend is fixed – rather than declared – and has priority over the common stock (hence the “preferred” label).
Also, in the unlikely event of a corporate liquidation, preferred shareholders stand ahead of common stock holders (but are secondary to bond holders).
Like common stock dividends, preferred dividends are taxed at the more favorable 15% maximum tax rate (20% if you’re in the highest tax bracket) – plus the 3.8% Obamacare surcharge.
That’s considerably less than the new top marginal tax rate of 37% on interest-bearing securities, foreign shares and real estate investment trusts.
If you want to be even more tax-efficient, own these in your qualified retirement plan where they will compound tax-deferred.
Preferreds are less volatile than common stocks, but they still bounce around. They fell during the recent financial crisis, for instance. However, they dropped only two-thirds as much as the S&P 500 and rebounded during the recovery.
Because of their fixed payments, preferreds – like bonds – are interest-rate sensitive. When rates go up, prices go down. And vice versa.
Unlike bonds, however, these securities may not mature for as many as 50 years – if ever. (One caveat: If interest rates rise substantially, you could be holding lower-valued paper that a corporate issuer might not redeem.)
Preferreds have less upside potential than common stocks because the issuer typically has certain redemption rights. These generally include a “call” provision, where the company can buy out shareholders at face value five years after the issue date.
But here’s the real benefit: Preferreds are currently yielding around 6%. That’s higher than what junk bonds yield, even though preferred shares are less risky.
For example, you can get 6% (or better) yields in preferreds issued by solid financial companies like JPMorgan Chase, Bank of America and Capital One Financial.
Safer still, you could own a diversified portfolio of preferreds. Consider an exchange-traded fund (ETF) like iShares S&P U.S. Preferred Stock Index Fund (Nasdaq: PFF), PowerShares Preferred Portfolio (NYSE: PGX) or the riskier PowerShares Financial Preferred Portfolio (NYSE: PGF).
Or consider a closed-end fund like Nuveen Preferred & Income Opportunities Fund (NYSE: JPC) or Nuveen Preferred & Income Securities Fund (NYSE: JPS). Both are liquid, sell at a 7% discount to their net asset values and pay dividends monthly.
The expenses are higher with closed-end funds because they are actively managed and able to use leverage to goose returns. The ETFs have lower expenses and are less volatile (since prices hew closer to net asset values).
Here’s the bottom line: With preferred shares, you get an attractive fixed yield, a more secure position than ordinary stockholders get, more favorable tax treatment than with interest-bearing securities and less risk than with common stocks.
They deserve a place in the portfolios of investors looking for income, safety and broader diversification.
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Source: Investment U