Preferred stocks yielding 6 percent plus

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Daren Fonda

An aura of income is all it takes to lure investors to dividend-paying stocks these days. But if payouts on common stocks don’t hold much appeal to you, consider a company’s preferred shares.

Even with their prices hitting 52-week highs, many high-quality preferreds still yield 5 percent or more. These stocks may not have much potential for gains after running up in price this year. But they should still generate more income than many other yield-oriented investments, including government bonds (1.5 percent for 10-year Treasuries), property-owning real estate investment trusts (an average of 3.6 percent) and utilities (3.4 percent).

Preferreds straddle the gap between stocks and bonds. Like stocks, they trade on exchanges. And like bonds, they make regular, though fixed, payments to investors. But bonds pay interest, while preferreds pay dividends, typically every three months. Many preferreds pay so-called qualified dividend, which can be a tax benefit: The top federal tax rate on those payouts is 15 percent, compared with a top rate of 43.4 percent on interest income.

Some risks

Companies typically issue preferreds at $25 per share. Prices may drift above or below that level, typically moving up as interest rates fall and moving down when rates rise. Critically, companies can “call,” or redeem, their preferred stock at $25 per share at a specified date in the future or, in some cases, at any time.

So paying close to $25 for a preferred stock gives you some assurance that if a company does redeem the stock, you won’t lose much of your initial investment. But be careful not to buy a preferred well above $25 a few months before its initial call date. Doing so could saddle you with losses, even after accounting for dividend income.

Companies may also have some leeway to suspend dividend payments. If a preferred is “cumulative,” the firm must eventually shell out any dividends it didn’t pay. But many preferreds are “non-cumulative:” If a company runs into financial trouble and suspends payments, it isn’t required to make good on the missed disbursements at a later date.

Preferreds have other risks, too. They aren’t as stable as high-quality corporate bonds, and that can sting in the event of
a market panic. In 2008, for instance, iShares U.S. Preferred Stock (symbol PFF, $40.04, yield 5.4 percent), an exchange-traded fund, posted a total return of -24 percent, after accounting for dividend payments. (Prices and yields are as of August 22.)

Today’s high prices have pushed yields down, providing less of a safety net if the market takes a tumble. In such a pricey environment, it’s important to stick with high-quality preferreds, which are likely to hold up better than lower-quality preferreds during a selloff, said Michael Greco, chief investment officer of GCI Financial Group, a money-management firm.

Because preferred dividends are fixed, the stocks would also slump if interest rates were to rise. A preferred trading at $27, for instance, could drop to $22 if the yield on the benchmark 10-year Treasury bond were to climb to 2.5 percent.

However, most experts don’t see a big rise in bond yields anytime soon. On the other hand, interest rates could spike if inflation becomes more of a concern down the road.

Stocks to consider

For access to a diverse package of stocks, consider the iShares preferred ETF. It holds more than 280 preferreds issued mainly by banks, real estate firms and insurance companies. Most of these firms carry investment-grade ratings, although the ETF does own some with lower ratings. Its annual expense ratio is 0.47 percent.

For a bit more income, consider buying one or more of the four preferreds described below. Note that ticker symbols for these stocks aren’t consistent across brokerage firms and financial websites. If you can’t find a symbol, visit www.quantumonline.com, a free site where you can look up preferred share classes by entering the issuer’s name.

AmTrust Financial Services, 7.75 percent Dep Shares Non-Cumulative Preferred Series E (AFSI.E, $27.00, 7.2 percent)

AmTrust specializes in small-business insurance, selling coverage for workers’ compensation, extended warranties and other types of property and casualty insurance. Revenues should hit $4.7 billion this year, up from $4 billion in 2015, according to Wall Street estimates. Analysts see the firm booking profits of $470 million in 2016. The company earns a solid A rating, moreover, from A.M. Best, a firm that evaluates the financial health of insurance providers.

AmTrust’s preferred looks attractive for its above-average yield and secure payout, said Greco. The firm paid $11.6 million in preferred dividends in the second quarter of 2016, well below its profits of $135 million. Shares aren’t callable until March 2021, and the dividends qualify for the 15 percent tax treatment. However, they aren’t cumulative.

Citigroup, Inc., 8.125 percent Dep Shares Series AA Non-cumulative Preferred (C.P, $27.68, 7.3 percent)

After suffering a near-death experience during the Great Recession, Citigroup now appears to be on much sounder footing. The giant bank, which holds more than $2.1 trillion in assets, recently passed its annual Federal Reserve “stress test,” winning permission to more than triple its common stock dividend and buy back up to $8.6 billion in shares over the next year. Analysts expect the firm to report $21 billion in profits in 2016 on revenues of $69.9 billion.

Citi’s improving finances bode well for its preferred stock. Although the shares trade well above par value, they still offer a generous yield. Dividends qualify for the 15 percent tax treatment. However, payments aren’t cumulative, and Citi can redeem the stock in February 2018.

JPMorgan Chase & Co., 6.70 percent Dep Shares Non-Cumulative Preferred, Series T (JPM.B, $28.02, yield 6.0 percent)

The largest bank in the U.S., with assets of more than $2.4 trillion, JPMorgan runs a massive and sprawling financial business. Its balance sheet and capital levels have improved sharply since the financial crisis, and it’s now soundly profitable. Analysts forecast $20.6 billion in earnings this year on revenues of $96.2 billion.

JPMorgan issues many classes of preferred stock. But the recently issued Series T looks like one of the most compelling now. Dividends qualify for the 15 percent tax rate, but they aren’t cumulative, and the bank can redeem the stock in March 2019.

KKR & Co. 6.50 percent Series B Non-Cumulative Preferred (KKR.B, $26.70, 6.1 percent)

KKR owns more than $30 billion in investments, ranging from private equity to ownership stakes in publicly traded firms, such as HCA Holdings (HCA), Walgreens Boots Alliance (WBA) and U.S. Foods Holdings (USFD). KKR also generates income from hedge funds and other investments.

Bank of America Merrill Lynch rates KKR’s common stock a “buy,” seeing improvements in the business and a rising level of fee-based income as the firm diversifies its revenue streams.

KKR’s profits can still be erratic. But its preferred dividends look solid. Analysts expect KKR to earn $394 million this year, providing ample coverage for its payout of $15.8 million on preferred shares. The dividends aren’t cumulative, and they don’t qualify for the 15 percent tax rate. But KKR can’t redeem the shares until September 2021.

All contents © 2016 the Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.