Preferred stocks are some of the best sources of income that many investors don't know about.

    According to Gregory Phelps, co-manager at Boston-based MFC Global Investment Management, which sub-advises $5 billion in preferred stock funds for John Hancock, preferred stocks make up 5% of all the U.S. capital markets and 10% of all fixed-income securities. But ask financial advisors about preferreds, and most will shrug off your inquiry.

Why? Because they never bothered to study this security.

From a risk/return scenario, high-quality preferred shares are the best source of income around. However, because there is scant research on this asset class, virtually no media or independent reporting of any kind, and few professional sources of advice, few folks know anything about preferreds.

UBS preferred stock strategist Barry McAlinden provides a perfect example of the yield edge preferreds can offer investors by comparing a senior unsecured bond with a preferred share-both issued by HSBC Holdings Plc. The A+ rated long-term bond, with a 6.50% coupon maturing in May 2036, was trading fractionally above par in mid-August, offering a yield-to-maturity of 6.47%. That was about 146 basis points above the 30-year Treasury.

At the same time, HSBC's A-rated 6.20% preferred A series stock was trading several points below its $25 par price at $22.69. Because dividends typically accrue into the stock price, distorting actual yield, analysts pull out this accrued amount to generate the more accurate so-called strip yield. This created a yield of 6.94%. "So here's an obligation from a huge, reputable global bank," says McAlinden, "paying nearly 50 basis points more than a comparable bond."

Not bad. But the story gets even better.

When the government lowered the tax rate on dividends from an investor's nominal rate to a flat 15%, this was a little-known boon for preferreds that qualify for this rate-like HSBC's.

If we consider a high-net-worth investor in the 35% federal tax bracket, his after-tax yield on the bond is 4.21%. For the preferred, taxed at just 15%, his after-tax yield is 169 basis points higher or 5.90%.

Another way to compare these two securities is to do a simple calculation that tells us what a fully taxable bond would have to yield before taxes to match the income from the preferred. In this case, the answer is a whopping 9.07%.

Credit risk doesn't explain this huge yield spread. The answer lies foremost in market inefficiencies that come from a lack of information and familiarity with this very attractive class of securities.

The Basics

Preferreds don't rely on any financial alchemy to generate their high yields. They clearly benefit from the current favorable tax code. And over recent years, several different types of preferreds have evolved to serve different issuer needs, which we will discuss later. But the basic structure and advantages of this asset class have been around for decades. Preferreds are largely transparent, and unlike the income derivatives that have recently throttled the market, they are much easier to understand.

As a basic introduction, let's look at high-quality traditional $25 par issues. Unlike common stock, these preferreds are largely driven by interest rates and credit spreads. Why? Because they are purchased for their income. Issuers are committed to paying their dividends before distributing profits to common shareholders. But technically they aren't as secure as bonds because preferreds lie below debt in the corporate capital structure.

Accordingly, rating agencies typically rank preferreds one to two notches below senior unsecured debt. This is a primary reason why preferreds yield more than bonds. But investors don't have to compromise on the underlying integrity of the issuer to receive this extra return. As Phil Jacoby, co-portfolio manager at Spectrum Asset Management, the subadvisor for several Nuveen Preferred Income funds, explains, "Trading down the capital structure of highly rated companies is a safer way of securing higher yields than investing in senior securities of struggling firms."

Unlike bonds, many preferreds are perpetual, i.e., they don't mature. This means that for financial planning purposes, investors can't be certain of the value of preferreds at any future time. Value will be determined by the market. Most preferreds, however, are callable five years after their issuance and anytime thereafter, typically at their issue price. Preferreds, therefore, may trade closer to their par price as their call date approaches. But if interest rates have risen since the security was issued, the company would not likely redeem the preferred until rates came back down.

When interest rates move, the price of preferreds adjusts inversely, like it does with bonds. Rising credit fears, as we saw this past summer, can also exert downward price pressure as the preferreds' yields separate from risk-free Treasuries. Such forces can further widen preferred spreads over bonds, hitting their prices even harder because preferreds are lower down the pecking order than bonds.

However, many investors, like Eric Chadwick, co-portfolio manager of Flaherty & Crumrine's $230 million Preferred Income Fund, think we may be nearing the end of the rate cycle and thinks credit concerns were greatly exaggerated in mid-August. This means the market may be offering access to twin pluses: cycle-peaking yields and forward capital appreciation, assuming spreads and rates ease.

Outside of these macroeconomic factors that are out of a company's control, the basic risk investors face is whether a company will miss a dividend payment. Unlike a bond payment, a company can miss a preferred dividend without being in default. Buying preferreds with cumulative dividends offers some added protection, which requires an issuer to make up all missed preferred dividends before reinstating a common stock dividend.

However, when dealing with established companies known for their quality, a dose of reality helps cut through the nuances of preferreds. Gregory Phelps puts it simply: "For a company to miss a preferred payment is nearly tantamount to default." It would spook the market, he says. Common stock prices would tumble and borrowing costs would soar as the overall financial worthiness of the company would come into question. And if the dividends are not redressed quickly, there could be serious questions about corporate governance. Therefore, dividends would only be missed if the company were in very serious trouble.

Industries And Issues

Issuers of preferreds include banks, insurers, brokerages, utilities, telecom and cable companies, energy and real estate firms, industrials and consumer manufacturers. "With 70% of these securities in the eye of the recent storm-real estate and financials-preferreds as a group got hit especially hard during the midsummer selloff," explains William Scapell, director of fixed income at Cohen & Steers Capital Management in New York and co-manager of the firm's $2.1 billion REIT and Preferred Income Fund.

To Scapell, this turmoil offered an attractive entry point for new investors. And toward the end of August, yields had already retreated and prices had moved sharply higher. However, he has concerns that the quick return of investor demand does not assure a smooth recovery, since he expects further bumps ahead.

According to UBS' McAlinden, attractive domestic issues as of Aug. 24 included Public Storage Preferred Series K (with a nonqualified taxable strip yield of 7.51%), Wachovia's Preferred Series A (with a nonqualified taxable strip yield of 7.26%), National Rural Utilities (with a nonqualified taxable strip yield of 7.07%), Merrill Lynch Preferred Series K (with a nonqualified taxable strip yield of 7.00%), and MetLife's Preferred B (with a qualified tax-advantaged strip yield of 6.61%).

But the sweet spot of the market is foreign preferreds, which have consistently offered better yields than equivalently rated domestic securities. The reason, according to Dan Campbell, a capital markets consultant and former head of hybrid capital securities at Merrill Lynch and Deutsche Bank, "is the misperception that there's higher risk in buying foreign securities." So not only can investors enjoy higher nominal yields from quality bank preferreds issued by the likes of Royal Bank of Scotland (whose Series R has a qualified taxable yield of 6.72%) and Santander (whose Series I has a qualified taxable yield of 6.87%), they benefit further from the low dividend tax rate as well. And unlike common share ADRs, these preferreds have no direct currency risk since they are dollar-denominated, trading exclusively in the U.S., and do not track home-market shares.

Some Variations

It's essential for advisors to understand the different types of preferreds to exploit inefficiencies that can evolve in this thinly traded market. Variations involve debt that's wrapped in a preferred veneer, which are referred to as baby bonds, trust preferreds and repackaged preferreds. The purpose of these securities is bringing corporate bonds to the retail investor. Being backed by bonds, these preferreds are paying interest that's taxed at nominal rates. Accordingly, their current yields are usually higher than those of qualified preferreds, which makes them more appropriate candidates for retirement accounts.

There are unregistered securities called 144(a)'s, which are typically issued at $1,000 par value. Because these are private placements that don't trade on exchanges and which have lower disclosure requirements than publicly traded preferreds, they usually pay higher coupons. Still, they are agency rated, and many are quality issues that likely have an extensive public data record from previous public offerings.

Among the most intriguing preferred issues are dividend received deductions (DRDs). These enable qualified corporate investors to deduct 70% of their dividends, which sends their tax equivalent yields soaring. This perk is derived from DRDs being perpetual-their dividends are not deducted from the issuer's income statement. This permits them to be treated more like equity than debt on the issuer's balance sheet, and so they improve the issuer's capital ratios and credit rating.

Mutual Funds

The task of trawling for preferreds appears challenging, but advisors can consider a number of mutual funds that invest primarily in these securities to collect higher yields. With such funds, of course, you lose the transparency that comes with buying individual issues, i.e., knowledge of specific credit ratings, prices, yields, and call dates. But in exchange, you can get experienced management that can structure and constantly monitor a balanced portfolio of preferreds and is capable of responding to special opportunities, like those that appeared last summer.

Being primarily closed-end vehicles, these funds are never forced to sell off investments at inopportune times to meet a rush of redemptions.

But the chief benefit of being closed end is their ability to leverage up to one-half of their assets. (One-third leverage, however, is most common.) That means that if an IPO raises $100 million, then the fund can borrow an additional $50 million at short-term rates that adjust between every seven and 49 days. This money is then reinvested in preferreds, which effectively boosts the yields of fund shareholders over those being earned by individual preferred investors.

The risk of leverage is that it exaggerates losses when preferred prices decline. "And as we saw this past summer when money markets short-circuited in August," explains William Scapell, "the cost of short-term borrowing can spike, significantly reducing the net margin spread over preferred yields."

Another risk and opportunity of closed-end funds is that they rarely trade at the underlying value of their investments, or net asset value. Their market value fluctuates from their NAV. During the summer selloff as investors moved away from credit products, discounts of some preferred funds collapsed toward the double digits, increasing market losses. "But this decline," Dan Campbell observed, "also provided new investors access to funds at 90 cents to the dollar, which boosted returns when the discount diminished."

Investing in funds spotlights the change in value triggered by shifting interest rates. Preferred funds soared in 2003 as the Fed dramatically cut interest rates, producing total returns in excess of 20%. Since the Fed started tightening monetary policy, annualized returns between 2005 and 2006 averaged between 5% and 6%. "The key point to remember during bouts of such volatility," explains Gregory Phelps, "is that investors continue to receive relatively high yields, and that over the long term as the market adjusts through interest rate cycles, preferred funds will generate solid total returns."