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QUESTION:
I don’t like to take risks with investments, and I
rely on income from my investments to cover living
expenses. I’m considering preferred stocks but have
never owned them. What do you think?
—J.
M.
ANSWER:
Preferred stocks have been yielding about 6 percent on
average, so they fit your desire for income.
But
these are not guaranteed like a U.S. government bond or
CD and are not as reliable as highly rated corporate
bonds. So they make sense only if you realize that the
higher yields are intended to entice people to take
greater risks. In other words, you might not get paid
dividends or get your original investment back if the
company that issued the preferred stock goes through
tough times.
As
the name suggests, a preferred stock is a kind of stock.
That’s important. It’s not as risky as common stock,
the type that you typically think of as the stock
market. But it’s not as safe as many bonds.
Some
people consider preferred stock a hybrid: part bond
because it pays income regularly and part stock because
there is no guarantee that you will get paid. It can
appreciate in value over time, but the opposite can
happen too. If you buy a preferred stock and watch it
day in and day out, the price will go up and down like a
common stock. If that makes you nervous, it’s probably
not right for you. But if you buy it to provide income
over maybe 20 years or more, and you have no intention
of selling it, you might have the mindset to look past
the fluctuations.
Minneapolis
financial planner Gregory Zandlo holds preferred stock
in retirees’ portfolios for 20 years or more without
reacting to price fluctuations. In August, he noted, the
ups and downs of preferred stock were about as dramatic
as the stock market’s. In 2008, the Standard&Poor’s
U.S. preferred stock index lost about 24 percent,
according to Morningstar.
But
rather than take such losses, Zandlo has clients buy
preferred stock with a maturity date. Those clients plan
to hold on to the stock until it matures, often over a
couple of decades. And only about 5 percent of the
person’s portfolio is invested in preferred stocks.
Besides the risk of declines during stock market
fluctuations, preferred stocks also lose value if
interest rates climb, a distinct risk in the years ahead
given ultralow rates now.
“You
wouldn’t want to have to sell it” during a volatile
period of sharp losses, said Zandlo. “My clients hold
for income and don’t get out.”
Still,
even someone who plans to hold onto preferred stock for
20 years needs to realize there could be another risk.
If the company that issued the stock goes bankrupt, you
could lose your investment. In a bankruptcy, people with
bonds are paid all or some of what they are owed before
anyone with preferred or common stock.
Even
if a company stays out of bankruptcy, it might not be
able to make the dividend payments investors expect on
their preferred stock. Unlike a bond, the company is not
obliged to pay preferred stock holders under difficult
conditions.
Because
of the risk, Zandlo said, it is important to make sure
to evaluate a company’s cash flow before buying a
preferred stock. Yet, even if a company can pay
dividends now, conditions can change over 20 years.
Consider what happened to retirees with preferred stock
in Fannie Mae and Freddie Mac. Through 2007, brokers
were selling the preferred stock as a safe investment to
people who wanted income, but by 2008 the institutions
were collapsing, and investors were shocked at losses.
Currently,
people must be especially careful about preferred stocks
because most of them come from financial institutions,
and financial troubles are not over. That is especially
evident in Europe, where banks are exposed to government
bonds from countries like Greece that may default. If
European banks end up in crisis, U.S. banks will likely
be affected.
While
one can try to select a preferred stock from a
nonfinancial institution, a preferred stock mutual fund
or exchange-traded fund likely has significant bank
exposure. For example, Morningstar analyst Timothy
Strauts noted that more than 80 percent of the iShares
S&P U.S. Preferred Stock ETF is in financial
companies. He also said investors should be aware that
new regulations require banks to redeem about $150
billion in preferred stock in 2013. In the short run,
that could support prices, but it also will limit
capital appreciation in preferred stock funds.
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