Solving The Market’s Most Challenging Issue


Preferred Stock ETFs: The Market's Most Challenging Issue


Last week, my colleague Alan Gula wrote about the “reach for yield” phenomenon, noting that preferred stocks have avoided the mania so far.

This is important, because searching for income has become extremely challenging in today’s environment.

Fortunately for us, there are a number of preferred stock ETFs to choose from – nine, according to the ETF database website.

But their unique characteristics could raise red flags for some investors.

So which ETFs present the best opportunity for income investors right now?

Generally speaking, preferred stocks are appealing to income investors – especially those in high tax brackets – because a majority of the dividends are “qualified” like common stock dividends.

That means dividends from preferreds are taxed at a maximum rate of 20%, rather than the 39.6% at which interest income is taxed. Thus, the yield is quite attractive.

Meanwhile, investing in a broad-based ETF of preferred stocks can help minimize risk and maximize income.

One reason is that preferred stock dividends are fixed, much like interest on a bond. In some cases, the preferred stocks are convertible into common stock, but the preferred stock ETFs generally invest in securities without conversion rights.

Meanwhile, preferred stock dividends carry a higher priority than common stock, and dividends must be paid to preferred stockholders first (though bonds still take priority over both).

Plus, many preferred stock dividends are cumulative, meaning if a company fails to pay the dividend in a particular year, it must make it up in subsequent years. For instance, Ford (F) failed to pay preferred stock dividends in 2009, but it paid them on top of regular dividends in subsequent years.

It’s also worth noting that the yield on a preferred ETF will vary marginally as underlying preferred stocks mature, or are sold and replaced with new holdings. Still, buying a preferred stock ETF is generally more satisfactory than buying individual preferred stocks – an ETF offers risk diversification and helps investors avoid the poor liquidity of many preferred stocks.

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