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Reaching for Yield: Preferred Stock

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In this continuing series exploring different ways investors might attempt to increase the annual income received from their portfolios, we look at preferred stock, a special equity security that has properties of both equity and debt instruments. In general, preferred stockholders receive a perpetual fixed dividend. In the event of a company bankruptcy, the seniority of their claim lies between the bondholders and the common stockholders. The issuing company may not pay a dividend to its common stockholders until it has satisfied its obligation to the preferred stockholders. Often, the company may call back its preferred stock in the same manner that it may call back a callable bond issue. This would normally happen when either interest rates decline or the company’s prospects have improved to the point where it now has a lower cost of capital. Either way, the preferred stockholders may have to face the problem of reinvesting their capital in a lower return environment. Preferred stockholders generally do not have voting rights, but their dividends may be considered a claim on future company earnings. One common criticism of preferred stock is that owners do not participate in any future earnings and dividend growth of the company.

One potential vehicle for capturing the returns of preferred stocks is the iShares Standard & Poors U.S. Preferred Stock Index Fund (PFF) which has a yield of 7.20% and an annual expense ratio of 0.48%. The fund itself began operations in March of 2007, and the eponymous index used by the fund began in October of 2003. So far, the data is not encouraging, as seen in the chart below. While the time period is too short to draw any statistically significant conclusions, preferred stock has shown equity-like volatility while returning less than indexes based on common stock such as the S&P 500 Index. Over the same time period, investors could have received the same return in Short-Term U.S. Government Bonds at a fraction of the risk. The fact that two of the most reputable mutual fund companies, Dimensional and Vanguard, have avoided opening funds based on preferred stock should be an indication to investors that the risk and return characteristics of this asset class have not offered anything above and beyond what investors have obtained with a mix of common stock and high quality bonds.