People Like Buffett Have Made A Killing With Preferred Shares Lately. But Does That Make Them Attractive For Regular Investors?

When I talk about dividend stocks here at Money and Markets, I almost always mean common shares of a company.

But today I want to tell you about another class of stock that some income investors gravitate toward: “Preferred” shares.

As the name suggests, preferred stock gives its owner a leg up on common shareholders, especially when it comes to dividends.

Preferred shareholders may receive larger payments, and companies are required to pay these dividends before distributions are made to common shareholders.

This DOES NOT mean the dividend is guaranteed. It simply means that when it comes down to the wire, preferred dividends are going in the mail before common dividends.

Should things get really bad, preferred stockholders also get to “pick the carcass” before common shareholders. Of course, Uncle Sam, secured creditors, and bondholders are even further up the line.

The dividend payments on preferreds can be fixed, adjustable, or determined by periodic auctions. Some are “cumulative,” which means a company must add any missed dividends to future payments during the time the stock is held.

One other crucial thing about preferred dividends: Only some qualify for the 15 percent dividend tax rate. These are known as “traditional preferred” stocks.

In contrast, any income from “trust preferred” shares will be taxed at your ordinary income rate. That is because they are technically considered debt securities.

If it’s starting to sound like preferred shares are a hybrid of common stocks and corporate bonds, that’s because they are!

Guys Like Buffett Have Made a Killing With Preferreds Lately. But Does That Make Them Attractive for Regular Investors?

Some critics argue that preferreds give investors the worst of both worlds - limited participation in earnings growth yet fewer rights than bondholders.

However, savvy people were snapping up high-yielding preferred shares as markets around the world crashed. So clearly some important market participants believe they can be good deals.

Warren Buffett is probably the most prominent proponent of preferreds, and two of his bets made a year ago were well publicized:

First, on September 29, 2008, he bought $5 billion in preferred shares from Goldman Sachs (GS). In the bargain, he secured a 10 percent yield. (Goldman’s common shares were yielding about 1 percent at the time!)

Then, just one week later, he plunked another $3 billion on preferred shares from General Electric (GE). Again, he locked in a 10 percent yield.

Plus, in both cases he received warrants that gave him the right to buy shares of common stock in each company. Both agreements provide five-year windows for purchases. The prices were $22.25 for GE and $115 a share for GS.

With GS shares currently trading at $171, you could say Buffett’s Goldman bet has worked out quite nicely. (And I expect the GE position to work out over the long-term, too).

However, there is some truth to the notion that Buffett and other prominent preferred investors get access to deals that regular investors will never see. Not just during major crises but all the time!

More to the point: Investing in individual preferreds takes serious research and effort.

There can be multiple classes of what appear to be the same shares …

Yields are not always written in stone …

Ticker symbols and naming conventions get confusing …

The vast majority of the issuing companies are financial firms …

And the list of pitfalls goes on and on.

I would also note that preferred shares have been extremely volatile as investors try to get a handle on the issuing companies’ credit strength.

So …

In Most Cases, I Still “Prefer” Common Dividend Stocks. However, If You Want a Stake in Preferreds, Try a Fund …

In my book, common shares of dividend-paying stocks are a better choice for most income investors, and should still comprise the bulk of your portfolio.

They are more readily available from a wide range of companies in different sectors and industries … are easier to buy and sell … and many still offer very healthy yields.

Meanwhile, you can get “front of the line” creditor standing with corporate bonds. And many riskier issuers are still offering high yields right now.

However, if you still want to dabble in preferreds, I think your best way to go is using an exchange-traded fund (ETF) or a mutual fund that specializes in preferred shares.

You will avoid most of the hassles I mentioned a moment ago and get solid diversification in one shot. Just remember that financials are still likely to remain a huge component of the overall fund no matter what its label says.

As you’d expect, the ETFs tend to carry lower expense ratios and are generally easier to buy and sell … so those would be my first choices.

There are now at least three to choose from - the iShares S&P U.S. Preferred Stock Index (PFF), the PowerShares Preferred (PGX), and the PowerShares Financial Preferred (PGF). Yields are currently between 8 percent and 9 percent on these funds.

On the mutual fund side, note that you will not find choices from the big-name, low-cost providers like T. Rowe Price, Fidelity, and Vanguard. That’s because it’s hard for large funds to effectively participate in the market for preferred shares. In fact, Vanguard used to offer a preferred fund, but ended up shuttering it in 2001 for that very reason.

And no matter what preferred vehicle you choose, I would absolutely keep your overall investment limited to a relatively small portion of your broad portfolio.

Never forget that with a higher yield almost always comes a higher risk of loss.

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