Investors Rediscovering Preferred Shares

(Dow Jones) Investors are rediscovering preferred shares, lured by eye-popping dividend yields.

These complex securities are often described as a hybrid between stocks and bonds and are largely issued by banks and other financial services firms. They offer the prospect of annual payouts amounting to 6%, 7% or even more at a time when investment-grade bonds typically yield about 5%.

They also are both risky and complicated, with unusual features that require extra homework.

What to consider: Preferred shares' attractive yields come at a price: The payouts are typically fixed at the time of issue, so unlike with common stock dividends, investors can't count on the issuer ever raising them. A key question is whether preferreds are "cumulative," that is, whether suspended dividends accumulate until they are paid out. Another is what kind of tax treatment preferred dividends are eligible for, since some are "qualified," taxed at a maximum of 15%, at least until Washington decides otherwise.

Like bonds, preferred-share issues carry credit ratings from agencies like Moody's Investors Service. They may also be callable and mature on a specific date. But preferred investors don't stand as high as bondholders do on the credit ladder, so if an issuer fails, they might receive pennies on the dollar or nothing at all. Fears of just such failures sent trading prices for many preferreds plunging deep below their typical $25 par value during the financial crisis. Values have bounced back but investors shouldn't overlook the risks.

 
Our Survey

We asked three professional investors who are familiar with preferreds to examine five potential holdings picked to showcase the broad range of choices available to investors.

Among them: a closed-end fund from Flaherty & Crumrine Inc., a company with a long preferred-investing track record, and a newer index-tracking exchange-traded fund from iShares.

There were also three individual securities. Since banks' preferred shares represent about three-fifths of the $365 billion preferred market we picked two. But one, Royal Bank of Scotland Group PLC's (RBS, RBS.LN) Series T shares, whose dividend was suspended earlier this year, seems to offer far greater risks and potential rewards than J.P. Morgan Chase & Co.'s (JPM) Series J, a tamer bet. Our final example, issued by Vornado Realty Trust (VNO), a real estate investment trust, represents one of the biggest groups of preferred-share issuers outside the financial services industry.

Our panelists: Daniel Forth, head of strategic indexing, Wells Fargo Securities; Robert Wasilewski, a financial adviser in Glenelg, Md.; and Eric Weiss, a financial adviser in Miami.

To see the chart analyzing the five potential holdings, go to http://www.djnewsplus.com/docs/CI-PreferredSharesChart.pdf.