Hungry for High Yields

Investors aiming for retirement can earn market-beating returns from preferred stocks. But they're volatile, so weigh the risks carefully

by Marc Hogan

An entire generation of retirees will soon be looking for some new sources of income. While the first batch of baby boomers turns 60 this year, another 75 million are poised to hit that milestone over the next two decades. Meanwhile, nearly 37 million Americans are already above the traditional retirement age of 65, according to U.S. census data (see BusinessWeek.com, 10/16/06, "Making Your Parents' Golden Years Shine").

The aging population's hunt for income is one reason a growing number of investors have poured money into preferred stocks. In the past 15 years, the size of the preferred stock market has quadrupled, to about $200 billion, according to Standard & Poor's, though that's a drop in the bucket compared to the $16 trillion stock market and the $5 trillion corporate bond market. In fact, preferred shares offer income-oriented investors some of the advantages of both stocks and bonds.

"Preferreds," as they're often known, are a kind of company stock that carries additional rights beyond those of common stocks (see BusinessWeek.com, 5/12/06, "Preferred Investors"). Ideally, preferreds allow shareholders to grab higher yields than they could find in other asset classes. The shares require less capital outlay than bonds, and their low correlation to other asset classes can help diversify an investors' portfolio.

Still, preferreds can also be complicated, volatile, and risky. Some analysts and financial advisers say investors should stay away from the asset class altogether. "They're often sold to unsophisticated investors because the high dividend sounds attractive, and that makes them easy to sell," says Dan Danford, president of St. Joseph (Mo.) investment advisory firm Family Investment Center.

This week's Five for the Money looks at five tips for wresting income from the preferred stock market without getting burned. As always, investors should do their homework before buying any securities.

1. Know your asset class

Preferreds tend to act more like long-term bonds than like stocks, and they come in a variety of flavors. Investors favor them for their high dividends, which are typically guaranteed. The average yield of the S&P U.S. Preferred Stock index is 6.4%, compared to 5.4% for the Lehman Aggregate bond index and 1.8% for the S&P 500 index.

Just don't buy preferreds expecting capital appreciation, money managers warn. The price return value of the S&P U.S. Preferred Stock Index was essentially unchanged during the three years ended in September, 2006, even as the total return value of the index jumped almost 22%.

Like long-term bonds, preferreds can swing in price based on interest rates or changes in the underlying company's credit rating. Investors who owned preferred shares of General Motors (GM) or Ford (F), for example, saw the value of their holdings tumble when the automakers' credit ratings fell to junk status in 2005 (see BusinessWeek.com, 5/5/05, "GM, Ford Fall on Ratings Downgrade to Junk"). "People have to understand that they're getting a volatile investment," says Tom Meyer, chief executive of Marlton (N.J.)-based Meyer Capital Group. "If they can overlook that and take the coupon, that's fine."

Preferreds can also be a serious commitment. While most are issued with maturities of 30 years or more, some preferreds are perpetual, which means there's no maturity date. The market for preferreds is also less liquid than for common stock, so investors might face a wider spread between buy and ask prices.