Preferred stocks can provide investors with a lot of attractive income potential, and they come at favorable tax rates, but investors should proceed with caution before adding them to their portfolios. Preferred stocks are hybrid assets that combine the characteristics of bonds and stocks, and issuers include banks and utility companies. They trade on an exchange like stocks, but they pay investors a steady income quarterly. Besides touting attractive yields of over 6%, preferred stocks can also provide investors with tax-advantaged income. Preferred coupons are usually (but not always) taxed at the same rate as qualified dividends, at rates of 0%, 15%, or 20%. Meanwhile, interest payments on corporate bonds are subject to ordinary income tax, which can be as high as 37%. But investors who are attracted by these tax-advantaged yields need to deal with preferred stocks’ unique risk profile. “The preferred stock market is very complicated,” says Ken Walzer, a certified financial planner and senior vice president at Wealth Enhancement Group in Los Angeles. Walzer says these securities make up less than 15% of his clients’ fixed-rate bond allocations. “There are a lot of caveats,” he adds. Unique Features The preferred shares offered to retail investors are fixed at $25 face value. The coupons paid on these issues can be fixed for the entire term or can be “fixed-to-floating,” meaning the interest rate can be adjusted after a certain period. These securities have long maturities, and many apply in perpetuity. But they also often have call dates that allow the issuer to redeem them. In fact, issuers have been increasing the number of preferred calls in recent months, with more than $15 billion redeemed in the last three months, according to UBS Financial Services. “The calls have come primarily from bank issuers, with their currently callable fixed-to-floating-rate preferreds resetting at relatively high rates, sometimes above 9%, which is why they are being called,” Frank Sileo, fixed-income strategist at UBS’s Americas chief investment office, said in a June 21 report. When individual securities are called, investors must look for replacements. Finally, preferred stock holders are lower on the list to be paid if the issuing company goes bankrupt. Preferred stock investors get paid before shareholders, but they are well behind bondholders in the priority order. Because of these risks, investors buying preferred stock should pay attention to the issuer’s credit rating. For example, rating agency Standard & Poor’s considers companies with a credit rating below BBB- to be below investment grade. “The key thing about investment-grade rated preferred stocks is that they tend to be issued by higher-rated companies, even though they sit lower in the capital structure compared to traditional bonds,” said Colin Martin, fixed-income strategist at the Schwab Center for Financial Research. Getting in the Market Buying individual preferred stocks can be quite a feat. An alternative is to look for exchange-traded funds that focus on preferred stocks, a move that can help investors avoid excessive exposure to specific issuers or specific sectors of the market. Walzer highlighted the First Trust Preferred Securities and Income ETF (FPE). This actively managed fund has a 30-day SEC yield of 5.82%, a 2024 total return of about 5.8%, and an expense ratio of 0.84%. Additionally, about 71% of its holdings are in the BBB-rated range. Holdings as of June 26 include Wells Fargo and Barclays. It also has the iShares Preferred and Income Securities ETF (PFF), which has a 30-day SEC yield of 6.33%. The fund has a year-to-date total return of over 4% and an expense ratio of 0.46%. Wells Fargo and Citigroup are notable issuers in PFF’s portfolio, but it also includes lithium producer Albemarle and renewable energy company NextEra Energy. While yield and total return are important, they should not be the only criteria for buying an ETF. Be careful with expense ratios, as high fees can weigh on returns.
This asset can offer investors large yields at favorable tax rates.
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