'Boring' stocks that suddenly look hot

By Harry Domash

In normal times, preferred stocks would bore you to tears.

Banks, insurance companies, real-estate investment trusts, utilities and others sell them, instead of bonds, to raise cash.

When they sell them, the issuing companies set the issue price, typically $25, and the annual dividend, which usually remains fixed for the life of the stock. The initial dividend yields typically range from 5% to 7.5% or so.

What makes "preferreds" so boring is that their share prices typically don't move much. They have almost no appreciation potential. Barring a major drop in interest rates, a preferred issued at $25 would probably top out at $25.50. Investors buy them for the steady payouts, not to make a killing on the share prices.

But to state the obvious, these are not normal times. Right now, preferreds are downright exciting if you're looking for better returns in a bad market.

Beaten-down prices

Last summer, preferred share prices sank when investors realized that banks, investment houses and many other financial companies were stumbling and might not be able to come up with the cash to pay their preferred dividends.

Then things got worse. In September, the U.S. government took control of mortgage agencies Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) and stopped paying both common- and preferred-stock dividends. That news was enough to send preferred holders rushing for the exits.

Then Lehman Bros. (LEHMQ, news, msgs) failed, the feds stepped in to rescue insurance giant American International Group (AIG, news, msgs), and Wachovia (WB, news, msgs) and other banks sold themselves at bargain basement prices to stay alive. Even venerable Merrill Lynch (MER, news, msgs) rushed into the arms of Bank of America (BAC, news, msgs) to stave off bankruptcy.

Now, thanks to the massive intervention by the U.S. government and governments around the world, the credit markets have at least somewhat stabilized. Unlike a few weeks ago, cocktail conversation no longer revolves around which banks might go under next.

Because the U.S. government is propping them up, most banks' preferred shares have moved up from their October lows. But many are still bargains. Let's do the math.

The preferred math

The yield you get on a preferred, as with any dividend-paying stock, is the next 12 months' dividends divided by the price you pay for the shares. Bank of America, which by all accounts is here to stay, has preferreds that originally sold at $25 trading for $17 to $20 per share. That brings the yield to new buyers up to 8% to 9% instead of the original 7% or so.

But there's more. If and when the credit markets return to normal, B of A's preferreds will probably bounce back to $25 or so. That translates to 25% share price appreciation, assuming you pay $20 for your shares.

• Video: More on why preferred shares look good

Even shares of a staid utility such as New York's Consolidated Edison (ED, news, msgs), are trading more than 25% below their issue price and offer 6.5% yields versus their 4.7% original yield.

If you want to move up in risk, Citigroup (C, news, msgs) preferreds, currently trading in the $14 to $15 range, offer more than 60% price appreciation potential and are paying 11% to 12% yields. Here's what you need to know to buy preferreds:

Why they're favored

Although you buy and sell them the same as you would regular common stocks, preferreds are more like bonds in that they represent debt, rather than ownership. They're called preferred stocks because companies must pay dividends on them before paying dividends on regular, or common, stocks.

Theoretically, in a bankruptcy, preferred holders also have priority over holders of common shares. But preferreds rank below bonds, and, in practice, holders of both preferred and common stocks usually get nothing.

Most preferred shares are "callable," meaning the issuer has the right to call (redeem) them at the "call price" after a specified date (the "call date"). The call price is the original issue price. The issuer is not obligated to redeem the shares at the call date, and many preferreds continue to trade for years after the call date.

They seldom go above the call price, for the obvious reason. That's why, in most markets, you buy these for dividends, not price appreciation.

Ratings

Bond rating agencies such as Moody's and Standard & Poor's analyze issuing companies' financials and rate preferreds using a combination of letters, numbers, and plus or minus signs such as AAA, BA1 or B-. The details vary among agencies, but any rating starting with A, and three letter ratings starting with B, indicate investment quality.

Because the issuing companies must pay for the service, not all preferreds are rated. Many investors avoid unrated stocks, so financially solid but unrated preferreds may trade below similar rated shares. That presents additional profit opportunities for those willing and able to do financial-strength analyses on their own.

Cumulative versus noncumulative

When initially sold, a company designates its preferred-stock dividends as cumulative or noncumulative. If cumulative, the company, in theory, is obligated to pay the dividends. If it skips any payouts, it's still on the hook for the money and must pay the missed dividends before it pays any common-stock dividends and before it calls the preferred shares. If it doesn't pay common dividends and doesn't call the shares, it may not make up the missed preferred payouts.

For noncumulative shares, the issuing company has no obligation to make up skipped payouts.

Tax issues

For reasons too involved to detail here, the dividends from some preferreds are subject to the maximum 15% tax rate while others are taxed as ordinary income.

So it's best to hold the latter category in tax-sheltered accounts.

Finding preferreds

Quantum Online is the only resource I've found for detailed information on preferreds. Quantum's information comes from the original prospectus and doesn't include the current trading price or dividend yield. MSN Money provides current prices and is the only resource I've found for trading volumes and price charts. Both are needed for the analysis.

On Quantum, select "All Preferred Stocks" to see the complete list, or use the "Income Securities Screening Form" in the "Income Tables" menu to narrow your list (registration is required).

On Money, prefereds can be looked up like any stock using the symbol; see the above sidebar on the right-hand side headlined "Preferred-stock ticker symbols."

Continued: What to look for

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