Ask the Expert: Should Investors Show a Preference for Preferred Stocks?

Q: What are the advantages and disadvantages of investing in preferred stock over common stock?

A: Preferred stock is a sort of stock/bond hybrid that has “preferred” status, meaning it has a more reliable dividend distribution than a regular common stock, and a firmer claim to the company’s assets should it become insolvent and file for bankruptcy protection.

Preferred stocks have been paying fat dividends over the last few years, as struggling companies offer higher yields to attract investors. The dividend yield of the Standard & Poor's preferred stock index is around 8%, compared with 3.29% for the benchmark 10-year Treasury note.

Preferred stocks typically pay a set dividend every quarter, regardless of how well a company is performing. If a company’s board of directors temporarily suspends or eliminates dividend payments during times of financial crisis, preferred shareholders will eventually get paid -- common stock holders are out of luck. If the company is liquidated, preferred stock holders are also ahead of common stock holders in reclaiming assets (though not by much: bond holders and creditors have priority).

Much like bonds, preferred stock prices are influenced by interest rates -- when interest rates rise, preferred stock prices typically fall, and vice versa. Since preferred stock prices aren’t market-based, they have less potential for stock price gains than common stock. If a company has a solid earnings run, common stock holders might benefit from a jump in stock price, while preferred stock holders generally wouldn’t. And, unlike common stocks, preferred stocks have no shareholder voting rights.

If you like the idea of guaranteed dividends, along with the added layer of protection from corporate insolvency, then preferred stocks might be a good fixed-income addition to your portfolio. The amount of the dividend paid is based on the type of preferred stock you choose. Most preferred stocks are “true preferreds,” which means the dividends qualify for the current 15 percent tax rate. But there are so-called hybrid preferreds that behave more like bonds and pay distributions that are taxed at ordinary income tax rates. (Before investing, consult a financial advisor or tax planner -- in the current tax environment, you want to be certain you’re choosing the right investment.)

A guarantee of higher-than-average dividends sounds great -- until the company goes belly up. When investing in preferred shares, stick with companies that have solid earnings and low levels of debt. You can find a list of preferred stocks at QuantumOnline.com (registration required). But know that investing in preferred stocks can be difficult for individual investors, because many are only offered to company executiveand institutional investors. Those that are available to individual investors also tend to have extremely low volume, which can make trading tough in a market sell-off.

One alternative to investing in individual preferred stocks is to spread the risk by investing in the iShares S&P U.S. Preferred Stock Index (PFF) exchange-traded fund. The ETF currently has a one-year total return of 28 percent, with a dividend yield of 7.86 percent and a low expense ratio of just 0.48 percent.

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