In an effort to increase returns in the face of low interest rates, many investors have turned to preferred stocks. According to the Wall Street Journal’s"Intelligent Investor" column, increased investor interest is likely due to the stocks’ relatively high rates of return (which average at about 7 percent) and the fact that preferred stocks have first claim on a fund’s dividends (“Preferred Stock: Are Those Juicy Yields Worth the Extra Risk?” Wall Street Journal, Feb. 5, 2011). Additionally, the income from preferred stocks may be taxed at a lower rate than income from some other investments, including bond income.
Of course, there are problems with preferred stocks – perhaps very big ones – but, unfortunately, many investors are completely unaware of what those problems are. In his column, Jason Zweig of the WSJ summarized the pitfalls of preferred stocks for his readers:
First, while preferred stocks seem to be lower risk than conventional stocks and some bonds, they are not low-risk products. The interest on the stocks can be suspended at the issuer’s will and the stocks themselves can be retired without notice (also at the will of the issuer). Additionally, the vast majority of preferred stocks are based on the financial sector, which leads to an overconcentration in one area of the economy and increases the risk of loss. Overall, the level of risk in preferred stocks typically ends up being higher than some other investments, even that of junk bonds.
Second, the tax benefits of preferred stocks typically only apply if the preferred shares were held for a particular period of time. In many cases, the assets change often and the preferred shares may not be held in the fund long enough for the investors to receive the tax benefits. Since this isn’t anything the investor can control, it may be unwise to count on the lowered tax rate.