Preferreds: Top Picks in Income Niche

06/29/2015 9:00 am EST

Focus: DIVIDEND

Richard Moroney

Editor, Dow Theory Forecasts

Investors like preferred stocks because they pay hefty dividends. Provided you know what you are buying, the stocks make sense as niche investments, asserts Richard Moroney, editor of Dow Theory Forecasts.

Companies offer preferred stocks because shares are normally cheaper to issue than common stock and don’t dilute earnings the way a common stock offering does.

The S&P US Preferred Stock Index contains 302 stocks and yields around 6.2%. Financial stocks dominate the sector, accounting for 84% of the index.

Preferreds offer potential diversification benefits for stock investors, as only about 60% of long-term returns are explained by moves in the S&P 500.

Gauging the risk of preferreds can be challenging. Preferreds behave more like bonds than common stocks and can fluctuate with changes in interest rates. Thus, the potential for the Fed to raise interest rates poses a risk.

Preferreds are also sensitive to an issuer’s creditworthiness. Finally, most preferreds have a call date—when the issuer can redeem the shares—presenting reinvestment risk.

Risks aside, preferred stocks should appeal to tax-sensitive investors looking to generate dependable income. Many preferred stocks pay qualified dividends taxed at a lower rate than ordinary income.

While investors should not load up on preferreds, the shares offer an alternative to traditional income stocks. Below we list five preferred stocks appropriate for most subscribers, including three that qualify for favorable tax treatment.

All five have investment-grade credit ratings, yield at least 5.6%, trade at modest premiums to their call price, and aren’t callable until 2019 or later.

State Street, 5.90% D (STT-PD)—yielding 5.6%
Integrys Energy, 6.00% (IEH)—yielding 5.6%
Public Storage, 5.875% A (PSA-A)—yielding 5.8%
Northern Trust, 5.85% C (NTRSP)—yielding 5.7%
Wells Fargo, 5.85% Q (WFC-Q)—yielding 5.7%

If you want a basket of stocks without paying too much, look to iShares US Preferred Stock (PFF), an ETF that tracks the S&P Preferred index and charges an expense ratio of 0.47%. The fund, which pays only partly-qualified dividends, yields 6%.

Adventurous investors might consider Flaherty & Crumrine Preferred (FFC), a closed-end fund yielding 8.3% that uses leverage (borrowed money) to boost income and returns.

Subscribe to Dow Theory Forecasts here…

More from MoneyShow.com:

Seaspan: High Seas, High Yield

Preferred Play on US Cellular

Preferred ETFs

Related Articles on DIVIDEND