Preferred stocks can offer investors a lot of attractive income—and at a favorable tax rate—but they should be cautious before adding them to their portfolios. Preferred stocks are hybrid assets that combine characteristics of bonds and securities, and their issuers include banks and utilities. They trade on the stock market like stocks, but they also pay investors a steady income every quarter. In addition to attractive yields of over 6%, preferred stocks can also offer investors tax-advantaged income: Their coupons are generally—but not always—subject to the same tax treatment as qualified dividends, taxed at a rate of 0%, 15% or 20%. Meanwhile, interest payments on corporate bonds are subject to ordinary income tax rates, which can be as high as 37%. But investors who find these tax-advantaged returns enticing must contend with preferred stocks’ unique risk profile. “The preferred stock market is very complex,” says Ken Waltzer, a certified financial planner and senior vice president of Wealth Enhancement Group in Los Angeles. He said these securities make up no more than 15% of his clients’ fixed income securities. “There are a lot of caveats,” he added. Unique Features Preferred securities offered to retail investors have a fixed par value of $25. The coupons these issues pay can be fixed for the entire term, or they can be “fixed-to-floating,” meaning the interest rate becomes variable after a certain period of time. These instruments have long maturities — and many can be perpetual. But they also often have a call date when the issuer can redeem them. In fact, issuers have been increasing the number of preferred shares in recent months, liquidating more than $15 billion in the most recent three-month period, according to UBS Financial Services. “The calls are coming predominantly from bank issuers whose currently callable fixed- to floating-rate preferred securities are now floating and being reset at relatively high rates, sometimes above 9%,” wrote Frank Sileo, fixed-income strategist in the Americas chief investment office at UBS, in a June 21 report. When individual securities are called, investors must look for replacements. After all, preferred stockholders are at the bottom of the list of amounts to be paid should the issuing company go out of business. Preferred investors would be paid before shareholders, but are well behind bondholders in priority. Because of these risks, investors looking for preferred stock should keep an eye on the creditworthiness of issuers. For example, ratings agency Standard & Poor’s classifies companies with a credit rating below BBB- as below investment grade. “The key thing about investment-grade preferred stocks is that while they’re ranked lower in the capital structure than traditional bonds, they tend to be issued by higher-rated companies,” said Collin Martin, bond strategist at the Schwab Center for Financial Research. Tapping into the Market Shopping for individual preferred stocks requires a lot of legwork. An alternative would be to look for an exchange-traded fund focused on preferred stocks, a move that helps investors avoid getting too exposed to any one issuer or market sector. Waltzer highlighted the First Trust Preferred Securities and Income ETF (FPE). This actively managed fund has a 30-day SEC yield of 5.82%, a total return of about 5.8% in 2024, and an expense ratio of 0.84%. Additionally, about 71% of its holdings have credit ratings in the BBB range. Holdings as of June 26 include issues from Wells Fargo and Barclays. There’s also the iShares Preferred and Income Securities ETF (PFF), which has a 30-day SEC yield of 6.33%. The fund has a year-to-date total return of more than 4% and an expense ratio of 0.46%. Wells Fargo and Citigroup are among the notable issuers in PFF’s portfolio, but lithium producer Albemarle and renewable energy company NextEra Energy are also included. While yields and total return are important, they shouldn’t be the only deciding factors when looking for an ETF. Keep a close eye on expense ratios, as higher fees will eat into your returns.
This asset can offer investors high returns at a favorable tax rate
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