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Preferred Stock Isn't Always Preferable
By Reshma Kapadia
SmartMoney
11 February 2009
It’s an old saw but one worth repeating, especially in today’s market: If it sounds too good to be true, it probably is.
Today’s investors are looking for safety, and for many people that means yield—bonds, dividend stocks, anything to provide a little income. Perhaps that’s how the previously oft-overlooked category of preferred shares—a stock/bond hybrid with an average yield of 13% these days—suddenly took center stage. Add to that famed investor Warren Buffett ’s well-publicized forays into the preferred stock of General Electric and Goldman Sachs and you’re headed toward a full-blown craze.
Preferred shares are a hybrid security. They are in front of common stock when dividends are passed out. But to gain that privilege preferred shareholders give up voting rights. Preferreds trade like bonds, often with much lower price swings, both up and down, than common shares. And they often rip off higher dividend yields ; much higher these days. Preferred shares are yielding more than twice what the average bond fund does and nearly four times the average common stock.
Those higher yields, though, could be a sign of trouble—trouble that Buffett can negotiate away but the rest of us mere mortals could get socked with. The fattest yields on preferred shares are turning up in troubled industries where stocks have taken a beating. Investors need to be “more concerned about the return of the money than the return on the money,” says Dan Deighan, founder of family wealth specialists Deighan Financial Advisors. Dazzled by a particular yield? Take a good look at the financial health of the company, Deighan advises.
Not all investors have been doing that. Michael Deutsch, a securities lawyer at Singer Deutsch LLP, says that about 40% of the inquiries he gets from investors whose portfolios were stuffed with too much of one type of investment have involved preferred shares. “Traditionally, some brokers have sold preferreds as a safe opportunity to get high yield, which may be true a lot of the time but not true all of the time,” Deutsch says.
The preferred stock market is also “miniscule” compared with the common stock market, which means prices can swing wildly in low volumes and make it difficult to sell shares exactly when an investor may want to unload, says Ron Roge, a fee-only wealth manager. That’s not to say investors should avoid the group entirely. Roge recommends finding companies with strong balance sheets and low levels of debt rather than rely on their “blue-chip” status, especially in the midst of the current crisis. He also suggests looking at investment-grade corporate bonds, which may offer less in yield but also are less risky, as an alternative.
