Uncommon Valor

A kiss on the hand may be quite continental, but preferred stocks can be an investor's best friend. If you're not familiar with this type of security, its characteristics are a cross between a common stock and a bond. For years, large institutions were the biggest investors in traditional preferred stock, although new twists on the old formula of preferreds are making them more accessible and more interesting to individual investors.

Like common stock, preferred stock represents ownership in a corporation. On a company's balance sheet, it appears under the "equity" section. Unlike common stock, however, preferred stock may pay a set dividend--similar to bonds that pay a set interest payment. If a company's assets are liquidated, preferred stockholders are usually paid before common stockholders, but after debt holders, making preferred stock more attractive to safety-conscious investors than common stock (though less secure than bonds).

Preferred stocks are rated by Moody's and Standard & Poor to give you a sound basis upon which to judge their quality. Preferred stocks usually have higher dividends than their common cousins, making them more attractive to those looking for Mr. Yieldbar. Yet, as the name suggests, preferred stock is not for everyone.

On the downside, like any fixed-income security, many preferreds offer little protection from inflation. If interest rates rise, though you'll continue to receive fixed payments, your purchasing power will decrease. Higher interest rates are usually no fun for fixed-income investments of any kind, especially since the price of your stock will probably fall as well, adding insult to injury.

Of course, this scenario isn't a problem if you intend to hold your position, but should you decide to sell, you may run into another problem: illiquidity. Preferred stock issues are not as widely traded as common stock, so there may be a significant spread between the asking and bid price.

Despite these faults, income-oriented individual investors and corporations alike still find preferred stock attractive. The secret is to know what you're doing.

The Five-Year Itch

Unlike bonds, which have a set maturity, most traditional preferred stocks are perpetual. Having a security that requires perpetual dividend payments can be a drain on a company, so to induce investors to surrender their shares, a company may have to offer to buy them from their shareholders at a higher price--not always the preferred option.

Enter callable preferreds. Most preferred stocks issued today have call dates after which the issuer can "call," or redeem, the shares at a predetermined price. Here's how it works: Investors who buy a new issue of preferred stocks often have call protection for five years. That means the company can't call their stock during this period, but any time afterward the shares are fair game.

Many preferreds are called either at the issuing price or at a slight premium. This potential bonus is a boon for investors, too. Some companies also issue convertible preferreds that convert into a set amount of underlying common stock--at the company's convenience, of course.

The Misfits

Part of the beauty of preferred stock is its predictability--a set dividend, a perpetual life span, set payment dates. Unfortunately, it's the privilege of some preferred stocks to change their minds. In addition to standard, callable and convertible preferred stocks, there are adjustable-rate, cushion and cumulative varieties.

Like any fixed-income investment, preferred stocks are hurt by rising interest rates. To counteract the effects of inflation, consider adjustable-rate preferreds.

Here's an example of how they work: XYZ Co. series N preferred stock adjusts its dividend each quarter based on 85 percent of the highest yields of the 3-month, 10-month or 30-year Treasury bond. Let's say the 30-year Treasury has the highest yield of 7 percent to maturity. Multiply this rate by 85 percent to reset the adjustable-rate preferred's dividend to an annual rate of 5.95 percent (7 percent [infinity] 0.085 = 5.95 percent). If the preferred stock has a $25-per-share par (or issue) price, the dividend paid is $1.48 ($25 [infinity] .0595 = $1.48). This rate is in effect for one quarter, then the process is repeated. Almost all adjustable-rate preferreds have a "collar," or a minimum and maximum interest rate to which the dividend can be reset.

Should you need a more reliable dividend, cushion preferred stock could provide just the kicker you're looking for. The idea here is to purchase the higher coupon issues that have a greater likelihood of being called by the issuer. By purchasing higher coupon issues, you can collect a larger dividend payment. At the same time, there is a higher chance that your securities will be called, allowing you to reinvest the proceeds in potentially higher-yielding securities that may be available.

Dividends on preferred stocks are paid from a company's earnings. No earnings, no dividend. What's a preferred investor to do? Before you invest, ask your financial advisor whether the stock is cumulative preferred. If the company should run into difficulties, cumulative preferred stock must pay its shareholders all owed interest before it can resume its dividend payments on common shares.

Some Like It Monthly

Both common and preferred stock traditionally pay dividends quarterly. Income-oriented investors who need monthly payments can buy an assortment of issues that allow them to receive payments as needed. If you buy an issue that pays in January, April, July and September; another that pays in February, May, August and November; and yet another paying in March, June, October and December, all months are covered.

Some investors shy away from this idea because it seems too complicated. For them, several newer types of preferred securities may be just the ticket.

Monthly Income Preferred Securities (MIPS) represent a limited partnership interest in a company that exists solely for the purpose of issuing preferred securities and lending the proceeds of the sales to its parent company. In general, MIPS have the following characteristics: a $25 par value, New York Stock Exchange (NYSE) listing and cumulative monthly distributions; in addition, they are noncallable for at least five years, and provide the issuer with the option of temporarily deferring distribution payments.

For U.S. taxpayers, MIPS are considered limited partnerships, and monthly payments are considered partnership distributions. Investors will receive K-1 forms at year-end in place of 1099s. If the partnership suspends distributions, it may still allocate those amounts to investors, who will be liable to pay taxes on the income allocated but not yet received.

Quarterly Income Preferred Securities (QUIPS) are much the same as MIPS, but with quarterly payments.

Trust Originated Preferred Securities (TOPRS) are very similar to MIPS and QUIPS. A TOPRS is a special-purpose business trust that exists solely to issue preferred securities and then lend the sales proceeds to the parent company. TOPRS differ in the area of taxation: Holders will receive 1099-OIDs, unlike QUIPS and MIPS holders, who receive K-1s.

Quarterly Income Debt Securities (QUIDS) and Monthly Income Debt Securities (MIDS), two new types of preferred securities, consist of subordinated debentures, which have 30- to 50-year stated maturities. These debt securities feature a $25 par value, NYSE listing, quarterly or monthly interest payments, are noncallable for at least five years, and, like MIPS, QUIPS and TOPRS, provide the issuer with the option of temporarily deferring interest payments. Holders of QUIDS and MIDS receive 1099-OIDs at year-end.

If these securities seem less than easy to understand, they are. If you're counting on income payments, before you decide to take advantage of the excellent yields offered by these securities, remember that temporary suspension of the dividend could put a crimp in your income flow. Also, this may result in a tax liability for income allocated but not yet received. Partnership income reportable on a K-1 form could mean extra work at tax time, too. Be sure to talk to a tax or legal advisor before you proceed.

Lorayne Fiorillo is first vice president of investments at Prudential Securities. She presents retirement planning and personal finance workshops worldwide. For more information, write to her in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.

The Bus Stops Here

Large corporations such as insurance companies and banks have long been fans of preferred stock. The primary reason it is so attractive to institutional investors is that 70 percent of the dividends received from preferred stock are exempt from federal taxes. (Newer types of preferred securities are not eligible for this deduction, however, so consult your tax advisor.) These tax benefits aren't limited to giant corporations, either. Any C corporation can qualify. Ask your tax and financial advisors how you can apply this benefit to your corporate account.

Whether in cumulative, adjustable, monthly or quarterly versions, you can select preferred stocks to fit your form. Yes, preferreds can be an income-oriented investor's best friend.