Preferred stock can give you income and appreciation

A: If you're like most investors, you probably buy some common stocks and some bonds. They are by far, the most popular assets.

Many investors overlook preferred stocks. Preferred stocks have been around since the late 1800s and have been a key holding for many old-money families, says Kenneth Winans of money-management firm Winans International and author of Preferreds: Wall Street's Best-Kept Income Secret.

Preferred shares are a mix of stocks and bonds, which may contribute to investors' confusion.

Like bonds, preferred shares are commitments by a company to pay a set amount of interest to shareholders. And like bonds, in most cases, the payments you get from preferred stocks are taxed at your ordinary income tax rate. Preferred stock payments, most of the time, do not qualify for the lower capital gains tax rates.

But preferred shares have some characteristics that make them unique. First, just as with common stock, preferred stockholders are behind bond holders in line for a company's assets if it runs into a financial problem. If a company fails, money is repaid to bondholders first. This adds default risk to preferred stock, although bond holders don't usually do all that well if a company is liquidated either.

And, just as with dividends paid on common stock, a company may decide it no longer wants to pay the preferred dividend. Preferred stock owners, though, have a advantage here. If a company stops paying a preferred dividend, it isn't off the hook. The company must repay all the money it would have paid to preferred shareholders before it can pay a dime as a dividend to common shareholders.

Another important characteristic of preferred shares is that sometimes, but not always, they give their owners the right to convert that preferred stock into common stock at a prearranged price.

If you can buy bonds for income and stocks for price appreciation, why bother with preferred stock? The simple answer is they have been solid performers over the long haul.

Since 1900, preferred stocks have returned a 7.4% average annual compound rate of return, Winans says. That falls short of stocks' long-term returns of about 10%, but it tops the average 6.4% return of corporate bonds.

But before you rush out and buy preferred stocks, there are additional risks to be aware of. Firstl, as you'd expect since they have higher historical yields, preferred shares tend to be more volatile than bonds.

Preferred stocks lose value about 24% of the time, while corporate bonds only fall one in five years, or 20%, Winans says. And when they do fall, preferred stocks lose about 5.6% of their value, vs. a 3.5% average decline by corporate bonds.

Last year, preferred stock investors got a taste for the risk they took.The Winans International Preferred Stock Index (or WIPSI), which tracks the value of preferred stock, lost 13.8% of its value in 2007. That was the index' worst year since 1994. The Vanguard Total Bond Market index fund, meanwhile, gained 6.97% in 2007. The Vanguard index owns government bonds in addition to corporate bonds, so it's not a perfect benchmark, but it gives you the idea.

Many investors may decide the added risk is worth the additional return preferred stocks may provide. Certainly, with several high-quality companies paying 7% or higher yields on their preferred stock, now is a great time to consider the investment.

There's another wrinkle, though. Actually investing in preferred shares is somewhat problematic. The largest exchange-traded fund (ETF) currently available that tracks preferred stock is the iShares S&P U.S. Preferred Stock Index fund (PFF). However, this ETF is built in such a way it is heavily weighted toward preferred stock from financial companies, including mortgage companies such as Countrywide Financial. Since financials are doing so poorly, that has dragged down the performance of the ETF. It also has a huge 9% weighting in Ford Motor's preferred stock. The ETF may not be ideal for investors looking for a diversified basket of preferred shares.

There are also several closed end mutual funds that own preferred shares. But, as is the case with most mutual funds, the performance of these funds has largely lagged market benchmarks.

That means investors interested in preferred stock may be best off, for now, buying shares of individual preferred stock, Winans says. But that not only exposes investors to company-specific problems, but also requires investors to do their own research on the companies. "For the smaller investors, a tough area to buy into," Winans says.

One suggestion might be to look at preferred stocks as something to buy in addition to or instead of owning the stock. If you own Ford stock and want to hold it, you may consider adding Ford preferred stock. You can get a list of preferred stocks in Barrons' or at epreferreds.com. There is a charge, though.

As an alternative, you can check out QuantumOnline.com, which offers free registration. QuantumOnline has a list of all preferred stocks, and a list of preferreds that qualify for the 15% tax rate. They can be found under "Income Tables" on the site.

Finally, some readers wonder if now's a good time to scoop up preferred shares of some of the troubled financial firms. Some investors are betting that even if these firms suspend their preferred dividends, if they wait five or ten years, eventually they will be paid. Remember, companies must pay investors the preferred dividends they owed, even if they weren't paid when they were due.

While it's true the dividends could eventually be paid out, Winans points out one giant catch: The dividends aren't inflation adjusted. Let's say you buy shares of a company that pays $1 in preferred dividends. And the company stops that dividend and doesn't pay it for 10 years. If you wait 10 years to get the dollar, you're really only getting what's worth 74 cents, assuming 3% annual inflation. So, are you really making out?

The bottom line? Preferred stock can be an attractive investment for investors looking for income. But, there are important considerations. Preferred shares are riskier than bonds, so you may see larger short-term losses, which may be unacceptable in some more risk-averse portfolios. Second, there aren't many good ways to buy a diversified basket of preferred stocks yet. That may change. But in the meantime, you'll need to identify individual preferred stocks yourself, which may require more homework than you're willing to do.

Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Click here to see previous Ask Matt columns.