Copyright (c) 2004, 
Dow Jones & Company Inc. Reproduced with permission of copyright owner. Further reproduction or distribution is prohibited without permission.A GUARANTEED dividend sounds like a safe investment. Generally, it is -- unless it's attached to a preferred stock and interest rates are poised to rise.
Welcome to a corner of the stock market that's little talked about despite the more than $225 billion of these securities outstanding. Preferred securities are much more like bonds than stocks and thus particularly exposed now that the Federal Reserve seems ready to push rates up from historical lows.
Preferred stocks get little attention in part because, in effect, they're stocks in name only. The most basic preferred is sold at a low par price, often $25, and sports a fixed, quarterly dividend. The securities are listed on a stock exchange but don't carry voting rights in the company that sold them. They can be called, or redeemed, by the issuing company, though most preferreds are protected against calls for at least five years from the date they're sold. These characteristics help explain why the stocks tend to trail any rally seen in the common stock of the issuing company. In fact, capital appreciation on preferreds often amounts to very little.
About the only trait that makes preferred stocks, well, stocks, is that many, but not all, are listed as equity on the issuing company's balance sheet.
What preferred stocks do have are those steady dividend payments: They have preference over common stock in the payment of dividends -- thus the handle "preferred" -- and they also outrank common stock (but trail bonds) in the creditor hierarchy, meaning that preferred shareholders get paid before holders of common stock should the company go bust and still have assets to pay out. There are several types of preferreds, including those that convert into common stock or cash and those sold into trusts then resold to investors. But all of them pay fixed dividends.
It's the steady dividend that entices investors, particularly since changes in the tax code last year made ownership of dividend-yielding securities more attractive. A lot of preferreds have effective yields several percentage points higher than common stocks. Their yields also easily trump those of money-market funds and even better some corporate bonds.
But a sharp rise in rates can hit preferreds where they live: These steady-as-they-go securities can become volatile and lose value. A hit to the security's price can quickly erode the income investors are earning.
Part of the problem is that most preferreds are "perpetual," meaning they have no maturity date and thus carry the interest-rate risk of very long-term bonds.
"This is not an area where you want to tread lightly," says Kurt Reiman, a senior strategist at UBS Financial Services who follows preferred securities and currently recommends clients underweight the sector.
In fact, rates don't even have to move all that sharply by historical standards to blindside preferreds.
Mr. Reiman has put together a "shock analysis" that forecasts what could happen to a theoretical portfolio of debt-by-any-other-name preferred stocks once rates start rising. His analysis assumes securities are held for six months. It shows positive returns for several call dates of preferreds should rates rise only a quarter point. But starting at half a percentage point of rate increases, the wheels start to come off: At that point, preferreds with six months to two years of call protection would produce a total return of 1.81%; those with two years to 3 1/2 years of call protection would lose just over 1%; and preferreds with 3 1/2 to five years of protection would shed 3.8%.
Andrew Montalbano, a preferred-securities trader at Advest, says, "If we go up 50 basis points [or one-half percentage point, in interest rates] you'll see some panic selling."
Yet Mr. Montalbano says it's still a good time for individual investors to buy preferreds, despite potential Fed rate action later this year, because the highest-quality securities are readily available and offer yields that are attractive enough to make up for principal risk. "I think it's a fine time to buy right now, because you get your 7%," Mr. Montalbano says.
Preferreds' principal risk stems in part from the fact that older preferreds offering the highest coupons are also likely to be trading above their $25 par value. These securities also are near their call dates, and upon being called will pay off at par, meaning a shareholder would lose the difference between the current market price for the security and par.
So, a 7% or 8% yield on a preferred that can be called in 2006 or 2007 effectively is a couple of percentage points lower, but still competitive with a corporate bond offering around 5% or 6%.
Donald Crumrine, chairman of Flaherty & Crumrine Inc., says an investor earning the relatively fat yield premium a preferred offers can afford to take a hit on the price of the security, "but at some point, interest rates will overwhelm." The Pasadena, Calif., firm specializes in preferred securities.
UBS's Mr. Reiman offers an example of how a preferred investor might be able to ameliorate the threat of rising rates by favoring older, more "seasoned" securities. Household Capital Trust VI is a high- quality preferred with an 8.25% coupon. Unlike perpetual preferreds, this trust preferred has a maturity -- in this case in 2031. But it's also callable as of Jan. 30, 2006, giving it an effective yield-to- call of 4.70%. That's a better yield than other securities due in 1 1/2 years.
If this sounds like a lot of work for an individual investor, it is. The amount of homework required is just one of many reasons many financial advisers don't recommend preferreds for their clients.
Those who do advise preferreds for their income-oriented clients sometimes recommend closed-end funds, such as those offered by Mr. Crumrine's firm.
One benefit of holding preferreds in a fund is that the funds can use options and other derivatives to manage portfolio risks.
"We don't try to predict rates," Mr. Crumrine says. "We hedge out interest-rate risk."
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Steady Rates Preferred
Preferred stocks pay a guaranteed dividend but carry no company voting
rights, making them more like bonds -- and about as sensitive to
interest-rate moves as bonds are. The table below shows how investors
holding a range of preferred stocks with different call, or redemption,
dates would be affected if rates were to rise over a six-month holding
period.
RATE SCENARIO: Current total return
TIME BEFORE STOCK CAN BE REDEEMED BY ISSUER
IN 6 MONTHS TO 2 YEARS: +6.06%
2 YEARS TO 3 1/2 YEARS: +6.82%
3 1/2 YEARS TO 5 YEARS: +6.58%
RATE SCENARIO: If rates rise 1/4 point
TIME BEFORE STOCK CAN BE REDEEMED BY ISSUER
IN 6 MONTHS TO 2 YEARS: +4.10
2 YEARS TO 3 1/2 YEARS: +3.00
3 1/2 YEARS TO 5 YEARS: +1.35
RATE SCENARIO: If rates rise 1/2 point
TIME BEFORE STOCK CAN BE REDEEMED BY ISSUER
IN 6 MONTHS TO 2 YEARS: +1.81
2 YEARS TO 3 1/2 YEARS: -1.02
3 1/2 YEARS TO 5 YEARS: -3.80
Note: Scenario based on May 6 prices for preferred stocks covered by UBS
Financial Services
Source: UBS
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