Personal Finance: Preferred stocks offer income, risk

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. 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 mind-set 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 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, Zandlo said. "My clients hold for income and don't get out."

Still, even someone who plans to hold on to preferred stock for 20 years needs to realize there could be another risk. If the company 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.

And unlike a bond, the company is not obliged to pay holders of preferred stock 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.

Currently, people must be 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.