Show #253 Airing: Sunday, April 25, 2004
Wouldn’t you prefer a safe, reliable investment that provides good income? Well, there’s a little-known investment that should “interest” you: preferred stocks. Here to explain why preferred stocks might be preferable in our portfolios is Elisabeth Plax, founder of Plax and Associates Financial Services.
One of the provisions of last year’s tax package capping the dividend tax rate of 15%, was that there would be no change in the tax treatment of preferred stocks. Why? Quarterly preferred stock payments are already classified as “interest” payments and not “dividend” payments.
The classification of these payments as interest and not dividends relates to how preferred stock securities are structured. Roughly 85% of issues in the preferred stock market are structured similar to bond issues. A little history is in order. Back in 1995-1996, corporations found a loophole in the tax code by setting up a holding company (usually a trust of some form) could still issue a preferred security and write off the interest expense rather than pass on it to corporate shareholders who receive a 70% tax exclusion on dividends. Thus, the hybrid preferred market (again, this now comprises the vast majority of investable preferred stocks) was born and the traditional DRD (Dividend Received Deduction) preferred market began to shrink in relative size. The cost of capital to an issuing company was equal to or less then a traditional DRD preferred issued. A retail investor obviously had no motivation to buy a DRD issue (which typically yield 2.0 to 3.0 percent less than hybrids) and, hence, most clients own hybrid preferred. Retail investors who happen to own DRD preferred will now be subject to15% dividend tax rate down from an individual’s marginal tax rate. With DRD issues yielding between 4 and 5 percent (depending on call features) and hybrids yielding between 6 and 7 percent, there will be no motivation for retail investors to look at DRD issues. Assuming a 4% DRD yield, the after tax (using 15% new tax rate on dividends) drops to 3.4% while for a hybrid yielding 6%, the after tax yield (using new top marginal 35% bracket for ordinary income) drops to 3.9%. The gap narrows significantly but not enough to warrant a shift.
Preferred stocks remain one of the better income-producing vehicles in the fixed income marketplace, and I believe they are worthy of consideration for any client dependent on income. Aside from individual preferred stocks, closed end funds are available in the secondary market. Please note that all of them incorporate leverage (30 to 47 percent), which could add to volatility. The leverage adds to volatility by increasing the duration, or interest rate sensitivity of the fund, while also boosting the dividend yield. Preferred stock closed end funds are also relatively new (all issued within the past 12 months) and so their return behavior going forward will be somewhat unknown. According to my research, preferred stocks have shown the interest rate sensitivity of 10t to 15-year corporate bonds despite the fact that they are issued with a 30-year, or perpetual, maturity date.
Aside from closed end preferred stock funds, investors may access the sector with a unit Investment Trust (UIT). Yields are similar to the above closed ends, but the UITs do not incorporate leverage. There are no open-end mutual funds focusing on preferred stocks.
It is important to remember that, historically, the value of fixed-income securities, including preferred stocks, decline in value as interest rates increase and increase in value when interest rates decline. Thus, the principal value as well as investment return will fluctuate, and an investor’s shares, when redeemed, may be worth more or less than the original investment.
Finally, you will also need to consider the merits of the tax aspects of preferred stocks. Dividends are now taxed at the same lower rate of long-term capital gains (max. of 25%) while interest income is taxed at the investor’s marginal tax rate (as high as 38%). Thus, those preferred stocks that qualify for dividend distributions may generate income that is taxed at a lower rate than those that create interest income. Consult your tax advisor to determine which may be more appropriate for your specific situation.
Gentlemen may prefer blonds. But we all may prefer stocks that pay more than bonds. If you’d prefer more information, give Elisabeth Plax a call and ask for her free preferred stock fact sheet.
Securities offered through LINSCO/Private Ledger (Member NASD, SIPC)
Source: Anthony Valeri, CFA, Asst. VP, Fixed income Research, Linsco/Private Ledger
