Preferred stocks pay nicely, but droop if interest rates rise

PERSONAL FINANCE

August 31, 2003|By EILEEN AMBROSE

LIKE MANY investors in the 1990s, retiree Thomas Devlin got swept up in the stock market euphoria, riding technology and other growth stocks up and then back down. His portfolio lost 30 percent from the height of the market in 2000 to fall 2001, and he was dipping into principal.

"After Sept. 11, I had no confidence of it rebounding," said Devlin, 72, who retired as a program manager with Westinghouse Electric Corp. in 1994.

That's when the Kingsville investor changed course. He dumped the growth stocks that once made up half his holdings and built an income portfolio made up largely of preferred stocks that pay high dividends. It worked. For the past two years, he's been able to live off the dividends generated by his portfolio, he said.

Preferred stocks, sometimes dismissed as staid or arcane, have become more popular as interest rates have dropped to levels not seen since Ike and Mamie slept in the White House. Many preferreds pay dividends ranging from 6 percent to 9 percent, experts said.

They are called "preferred" because their fixed-rate dividend is paid out before any dividends are distributed to owners of common stock. And if the company goes bankrupt, the claims of preferred shareholders take priority over those of common shareholders.

Preferred shares are more akin to bonds than stocks. New issues are sold at their face value, often $25 a share. Investors buy them for income, not for the chance that share prices will go up.

Some older preferred shares have no maturity date, while newer issues mature in 30 to 50 years, said Don Doan, who operates QuantumOnline, an online resource for information on preferreds and other income securities.

That means instead of turning maturing shares into the company to collect their principal, investors likely end up selling them on the open market, he said. And the price they get will depend on where interest rates stand at the time.

Just like with bonds, changing interest rates are one of the biggest risks of preferred shares. If rates go up, the price of shares go down and investors could lose principal. But if rates fall, the shares can demand a higher price.

"If someone thinks the economy will really strengthen and interest rates will go up, then they do not want to invest in preferreds nor do they want to invest in any bonds," said Steve Athanassie, a financial planner in New Port Richey, Fla. "However, if they think rates will stay stable or decline, then preferreds are a great place to invest."

Not every company offers preferreds. They often are issued by banks, utilities and old-time companies, including Citigroup Inc., General Electric and General Motors. About 1,600 preferred stocks are available to small investors, Doan said.

Before buying preferreds, experts suggest, investors need to consider:

Credit quality. Another risk that preferred stocks share with bonds is that a struggling company might default and investors will lose their principal.

Check out the company's credit rating, which gauges the likelihood of default, experts said. The higher the risk, the higher the dividend. Experts suggest sticking to investment-grade preferreds so the risk of default is low.

Call date. Like bonds, preferreds have a "call" date, the point at which the company can cash-out investors. Companies generally "call" preferreds if interest rates fall and they no longer want to pay a generous dividend.

"Just like a homeowner will refinance a mortgage, so will a company refinance its preferreds and bonds," said William Hummer, chief economist with Wayne Hummer Investments in Chicago.

He suggests looking for preferreds with call dates of three to five years out so investors have time to reap dividends that are often paid quarterly. "If you just buy preferreds for one or two years, it's pretty hard to come out ahead very much" after paying broker commissions, he said.

Taxes. Under a new law, dividend income is taxed at a rate of 15 percent, instead of the investor's regular income tax rate, which could be as high as 35 percent.

About 85 percent of actively traded preferreds won't qualify for the new tax treatment because their dividends are considered interest, Hummer said. Preferreds older than 10 years likely will get the favorable tax rate.

Investors should ask the company how the dividends will be taxed if there's any doubt, Hummer said.

Diversification. As they should with common stocks, investors need to make sure their preferred stock holdings are diversified, said Doan, who suggests owning at least 10 preferreds from different companies and industries. Devlin, for example, owns 22 preferreds spread across industries such as candy, fertilizer, theaters, restaurants and hotels.

Convertible preferreds. These allow investors to convert their preferred shares to common stock, allowing an investor to get income while speculating in the market, Doan said.

"It's kind of a hybrid in the industry. Do you want income? Do you want stock appreciation? A lot of people want both," Doan said. "There's nothing wrong with owning them as long as you understand what you are buying."

Because of the convertible feature, these shares pay lower dividends than standard preferreds, Doan said. The risk is that the common stock price falls, and an investor selling convertibles will take a loss.

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose @baltsun.com.

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