Sivy on Stocks

Preferred shares: uncommon values
Uncovering one of the best-kept secrets in fixed income.
August 18, 2004: 10:14 AM EDT

NEW YORK (CNN/Money) - Among income investments, one of the best deals often goes unrecognized -- preferred shares.

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The reason they can be such a good deal has to do with the way corporate balance sheets are put together. All corporations are financed with equity, represented by common stock. Most also borrow money, usually by selling bonds. The bonds have first claim on the company's assets, so they're the safest investment. But any increase in the company's value goes to the equity.

Preferred stock is a third category, falling between common stock and bonds. Preferreds have a stronger claim on company assets than common shares do, making them a safer investment.

And like bonds, preferreds have a fixed payout, with yields on many top-quality issues running as high as 7 percent. In addition, they're far more convenient than bonds, particularly for individual investors with limited funds. Most preferreds trade for around $25 a share, so you can buy a 100-share round lot for $2,500. It's generally thought that you need at least $10,000 to buy individual bonds efficiently.

Preferreds do have a few drawbacks. Unlike common stock, they barely benefit from increases in the company's value. Further, not all preferred dividends receive the same favorable tax treatment that most U.S. common stock dividends do. Finally, preferreds often can be called -- that is, redeemed early. If you pay more than face value for a preferred, and it's called, you'll face an immediate loss. Many preferreds are callable within four years of the date they're issued.

To lessen your call risk, you can buy recently issued preferreds. Or, you can buy preferreds selling for less than face value -- it's not so bad to be called at $25 if you only paid $22.

Not all companies issue preferred stock. And since there are so many variables to consider, there may only be a handful worth buying at any particular time. So you'd be smart to buy them through a knowledgeable broker. But even though top preferreds are hard to track down, they're worth the hunt. One or two well-chosen issues can be the perfect income additions for a broadly diversified portfolio.  Top of page

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