Fishing for Yield?

By Daniel Kadlec

Investors who want a decent return--but don't want to take on a lot of risk--have few choices. Many are turning to preferred stock, which comes in a handful of confusing varieties. There's convertible preferred, favored by investing legend Warren Buffett. Traditional preferred is bought mainly by insurance companies and pension-fund managers. But a relative newcomer, fully taxable preferred, is the best type of preferred stock to consider today, if a secure income stream is your goal.

That could change as early as next year. Lawmakers appear eager to reduce or eliminate the tax on dividends from common stock, and they may do the same for dividends from convertible and traditional preferred stock as well--though not for dividends from the new breed of fully taxable preferred. That prospect is driving up the prices of dividend-paying stocks.

Why aren't fully taxable preferreds in line for tax relief? They have so many bondlike traits that tax authorities treat the payouts not as dividends but as interest payments (where no tax changes are in store). So tax relief--if it ever comes--could tilt the table toward traditional preferred. As for convertible preferred, that should be thought of as common stock, which isn't the best way to generate an income stream.

Given the tax uncertainty, you may want to wait for some clarity. At this moment, though, fully taxable preferred remains your best option--and, as a kicker, these securities have rarely been cheaper. The average dividend yield for blue-chip fully taxable preferred shares is just over 7%, which is 1.4 percentage points higher than the average yield on blue-chip corporate bonds, according to Merrill Lynch. That's about as wide as the spread ever gets, and it means that investors today are promised a superior return with fully taxable preferreds. Among the best values out there, Merrill says, are the fully taxable preferreds of Comerica (yielding 7.44%), Torchmark (7.58%) and Virginia Electric & Power (7.26%). A handful of closed-end mutual funds invest in fully taxable preferreds, including the John Hancock preferred-income fund and three Quality Preferred Income funds launched this year by Nuveen Investments.

Around since 1993, fully taxable preferreds are also known as deferrable-debt hybrids. They pay a fixed rate over terms of 30 to 40 years and then return principal, akin to long-term bonds. Their dividends cannot be adjusted or canceled--only deferred for up to five years, by which time payments must resume or the company may be forced to liquidate. Traditional preferreds are truly stocks in that they do not expire and the dividends may be canceled or changed.

Fully taxable preferreds have higher yields than corporate bonds because they have features you won't like. Bondholders get paid first in bankruptcy. (Fully taxable preferred ranks ahead of traditional preferred and common stock.) More irksome: should your dividends be deferred, you must pay tax as though the dividends were paid in full. It doesn't happen often. "Companies do everything to avoid it," says Mark Lieb, founder of Spectrum Asset Management, a Stamford, Conn., firm that specializes in fully taxable preferreds.

But it happened last year with Southern California Edison. To guard against owing tax on phantom gains, investors should hold fully taxable preferreds in an IRA or other tax-deferred account. And because taxes paid on phantom gains can never be fully recovered if the company fails, Lieb says he invests only in high-quality companies.

Traditional deferreds are largely tax deductible for corporate holders but not for individuals. Fully taxable preferreds get the same treatment regardless of holder. They pay dividends quarterly, not twice yearly like bonds. And they are priced as low as $25 a share, rather than the $1,000 price for a new corporate bond. If you're stretching for yield in today's low-rate environment, they might be for you.