With the market looking weak, and banks
paying next to nothing in terms of interest, you should consider
shifting some of your cash to preferred stocks.
You can find many preferreds paying
dividends equating to 5% to 8% annual yields. Dividend yields (annual
dividends divided by your cost) are analogous to bank account interest
rates. However, your principal is not insured, so investing in
preferreds is riskier than keeping your money in the bank.
Nevertheless, if you apply a little
common sense when you make your selections, preferreds are a relative
safe bet in this market. Here’s what you need to know.
Although you buy and sell them the same
as stocks, preferreds are more like bonds. That is, they represent
debt, not ownership. You buy them for steady income, not for capital
gains. One word of caution, unlike bonds, a firm may suspend payment
of its preferred dividends without filing for bankruptcy. Thus, it’s
important to pick preferreds issued by companies with strong balance
Most firms issue preferreds at $25 per
share, although some go for $50 or $100. The issuer sets an annual
dividend (usually paid quarterly), which typically remains fixed. The
“coupon rate” is the dividend yield based on the issue price. In this
market, coupon rates vary from 4.5% to 8.5%, depending on the
perceived financial strength of the issuing firm.
An issuing firm can have its preferreds
credit-rated by agencies such as Moody’s or Standard & Poor’s. The
rating agencies use combinations of letters, numbers, and plus or
minus signs such as AAA, BA1 or B-. Details vary between agencies, but
any rating starting with A, and three letter ratings starting with B,
signal investment quality. If you want to be on the safe side, stick
with preferreds rated investment quality. However, since firms must
pay for the ratings, many issuers don’t have their preferreds rated.
Thus, an unrated preferred doesn’t necessarily mean that it’s not
Just like stocks, preferred share prices
vary with supply and demand. Currently, demand is high and most are
trading above their issue price. For instance, $25.00 preferreds are
typically trading in the $25.50 to $27.00 range.
Most preferreds are “callable” meaning
that the issuer has the right to call (redeem) them at the “call
price,” which is usually the same as the issue price. The shares can
be called at any time after the “call date,” which is typically five
years after the issue date.
Yield to Call
When considering a preferred selling for
more than the call price, that premium reduces your overall return.
“Yield-to-Call,” which is the annualized return that you would receive
if a preferred were called on its call date is the number that you
need to know. You can use MoneyChimp (www.moneychimp.com)
to calculate yield-to-call.
Once there, select “Calculator” and then
“Bond Yield.” It’s set up to calculate “yield-to-maturity” for bonds,
but you can use it for yield-to-call by entering your preferred’s
“years-to-call” in the “years-to-maturity” entry box. When you get
your answer, interpret “yield to maturity” as “yield to call.”
For practice, do the calculation for a
preferred with a 6.5% coupon rate trading at $26.50, and with 4.5
years to call. You should get 5.1% for yield to call.
What should you require for yield to
call? That depends on your needs. My rule of thumb is a minimum 4% for
investment grade preferreds and 5%t for unrated preferreds. Since many
preferreds are not called until long after the call date, your actual
return will probably exceed the calculated number.
You can use Quantum Online (www.quantumonline.com),
a free site, to find basic information about any preferred. You can
also use Quantum’s Income Securities Screening Form (Income Tables
menu) to find preferreds of interest to you.
To evaluate preferreds you’ll need two
items not shown on Quantum Online, the current trading price and
average daily trading volume. You can find those in the Investing
section of MSN Money (money.msn.com). While you need the price to
calculate yield to call, average daily trading volumes are also
important. Some preferreds trade at very low volumes, making it
difficult to buy or sell at reasonable prices. Look for preferreds
trading at least 5,000 shares daily, and higher is better.
As mentioned, the issuing company’s
financial strength is important. If you don’t want to analyze balance
sheets, as a rule of thumb, avoiding preferreds issued by firms whose
common stocks are trading below $20 per share should keep you out of
Four Preferreds For
Here are four preferreds that you could
use to start your research.
Aspen Insurance Holdings (ticker AHL-B):
issue price $25.00, recent price $26.80. Credit Rating BBB-, Call Date
7/1/17, Coupon Rate 7.25%, Yield to Call 5.2%.
Goldman Sachs Notes (GSF): issue price
$25.00, recent price $26.46. Credit Rating A-, Call Date 11/1/15,
Coupon Rate 6.125%, Yield to Call 4.0%.
Maiden Holdings (MHNB): issue price
$25.00, recent price $26.44. Credit Rating BBB-, Call Date 3/27/17,
Coupon Rate 8.0%, Yield to Call 6.3%.
Apollo Commercial Real Estate Finance
(ARI-A): issue price $25.00, recent price $25.71.Credit Rating NA,
Call Date 8/1/17, Coupon Rate 8.625%, Yield to Call 7.9%.