Are the High Dividends of Preferred Stocks Worth the Risk?

Harry Domash |

Preferred.jpg

With the market looking iffy, and banks still paying next to nothing in terms of interest, this might be a good time to take another look at preferred stocks.

You can find many preferreds paying dividends equal to 4% or even 7% 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.

Although you buy and sell them the same as stocks, preferreds are more like bonds. That is, they represent debt, not ownership. Although there are occasional exceptions, you usually buy preferreds for steady income, not for capital gains.

Getting to Know Your Preferreds

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 7.5%, depending on the perceived financial strength of the issuing firm.

Cumulative preferreds require issuing firms to eventually make up skipped dividends while non-cumulative preferreds don’t have that requirement. However, in practice, you’ll do best by avoiding preferreds issued by firms that might run into that problem rather than waiting for long-delayed cumulative dividends.

An issuing firm can pay to have its preferreds credit-rated by agencies such as Moody’s or Standard & Poor’s. The ratings, a combination of letters and numbers, vary between agencies, but any rating starting with A, and three letter ratings starting with B, signal investment quality. Since issuers must pay for the ratings, many choose to skip that step. Thus, the fact that a preferred hasn’t been rated doesn’t necessarily mean that it isn’t investment quality.

Pick Strong Issuers

Unlike bonds, a firm may suspend payment of its preferred dividends without filing for bankruptcy. Thus,the first priority is to pick preferreds issued by companies that are unlikely to run short of cash, and fortunately, doing so doesn’t necessarily require digging into financial statements. Instead, a little bit of common sense will go a long way. For starters, avoid preferreds issued by firms in troubled industries. Currently, firms owning crude oil and natural gas reserves fit that description. Next, check the issuing firm’s common stock trading price. Very low trading prices - say, below $5 per share - warn that many investors see problems ahead. So, as a rule of thumb, stick with preferreds issued by companies with common shares trading above $10 per share.

Calling Preferreds

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. 

High Premiums Cut Returns

Just like stocks, preferred share prices vary with supply and demand. Currently, demand is high, and many preferreds are trading well above their issue prices. For instance, many $25.00 preferreds are currently trading in the $26.00 to $28.00 range.

If you pay $27 for a $25 call price preferred, you’ll lose $2 per share when it’s called. Yield to call takes that loss into account and calculates your average annual return if you bought the preferred today and it were called on its call date. Obviously, it’s best to minimize the premiums over call price that you pay when you buy preferreds.

Recommended Preferreds

Here are five preferreds that are currently “buy” rated on my Dividend Detective site - each of which has recently traded no more than $0.50 above their call prices.  

Annaly Capital Series C ($NLY-C): issue price $25.00, recent price $25.19. Not credit rated (NR), Coupon Rate 7.625%, cumulative. Annaly, a real estate investment trust (REIT), invests in single-family, mortgage-backed securities that are guaranteed by U.S. government agencies. Its Series C preferreds would return 7.2%, on average, annually, if called on their 5/16/17 call date (Yield to Call).

General Electric Capital Corp 4.875% Notes (GEB) : issue price $25.00, recent price $25.31. Credit rating AA+, Call Date 10/15/17, Coupon Rate 4.875%, General Electric, a conglomerate sells products ranging from jet engines, gas turbines and railroad locomotives to consumer appliances and medical equipment. Yield to 10/15/17 call date is 4.4%.

Kimco Realty Class J ($KIM-J): issue price $25.00, recent price $24.62. Credit rating BBB-, Coupon Rate 5.50%.Kimco, a REIT, develops and operates neighborhood and community shopping centers in the U.S. Yield to 7/25/17 call date is 6.2%.

PartnerRe Series F ($PRE-F): issue price $25.00, recent price $25.48. Credit rating BBB, Coupon Rate 5.875%. A major reinsurance provider based in Bermuda, PartnerRe provides property & casualty reinsurance services (insures the insurance companies) in 150 countries. Yield to 3/1/18 call date is 5.2%.

United States Cellular Corporation 7.25% Senior Notes ($UZB): issue price $25.00, recent price $25.30.Credit rating NR, Coupon Rate 7.25%. U.S. Cellular Corp (USM) , majority owned by Telephone & Data Systems (TDS) , is the fifth largest U.S. cellular company, providing service to more than four million customers in 23 states. Yield to 12/18/19 call date is 6.9%.

Ticker Symbols Vary

Preferreds’ ticker symbols are not standardized. The symbols I’ve listed can be used on the MSN Money and TD Ameritrade websites. When you’re ready to buy, enter the issuing company’s name using your broker’s symbol lookup function. Most sites will respond by displaying all related preferreds in addition to the firm’s common stock.

 

For tips and information on the best utilities and dividend stocks from Harry Domash, please check out Dividend Detective

 

 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
GEB General Electric Capital Corp. 4.875% Nts due 10/1 24.80 -0.17 -0.68 57,331
TDS Telephone and Data Systems Inc. 29.26 0.00 0.00 661,875
USM United States Cellular Corporation 41.66 -0.10 -0.24 105,878
UZB United States Cellular Corporation 7.25% Senior No 25.16 0.16 0.64 36,686

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