COLUMN-Preferred stocks still make sense for yield

By John Wasik

CHICAGO, Aug 20 (Reuters) - Frustrated yield seekers havebeen drawn to preferred stocks because they offer aseveral-point yield advantage over most U.S. investment gradebonds, including Treasuries, corporates and municipal bonds.

But these quasi-stock, quasi-bond investments act like bondswhen interest rates rise: They fall in value. That has broughtthem some negative attention in the last few months. Preferredstocks declined in value as investors scrambled to findhigher-yielding vehicles when rates rose. They may now may beoversold and offer some bargains.

Preferreds straddle a territory between common stocks andbonds. Mostly issued by financial companies, preferred stocksconfer no voting rights, but represent a higher claim onearnings than common stocks, and are less volatile.

They also best the stock market's dividend yield by a heftyamount: The Standard & Poor's 500 stock index has a 2.01percent dividend yield, while an exchange traded fund that holdsthe preferred shares of the same companies is yielding 5.78percent.

In the event of a company's liquidation, preferredstockholders are second in line for corporate assets, behindbond investors. Buying a pool of preferreds throughexchange-traded funds can help you mitigate that risk.

The largest preferred-stock exchange-traded fund - the $10billion iShares S&P Preferred Stock Index - lost nearly7 percent in the three months through Aug. 16. It charges 0.48percent annually for management expenses, and holds shares frommegabanks such as Barclays Bank plc, Citigroup and Wells Fargo & Co.

Due to its nearly 6 percent yield, the iShares fund stillkeeps you slightly ahead of the bond market's recent volatility.It's up 0.25 percent over the 12 months through Aug. 16. Bycomparison, the Barclays U.S. Aggregate Bond Total Return Index,a benchmark for the U.S. bond market, which is down nearly 2percent.

"The main issue with preferred stocks is interest-raterisk," says Eric Dutram, an analyst with Zacks InvestmentResearch in Chicago. "There's no way around it."

MORE DIVERSIFIED ALTERNATIVES

Still, it's vexing to see a high-yield stock track the bondmarket. In a perfect world, that wouldn't happen and a preferredstock would offer a diversified option to high-yield bonds.

One way to sidestep some of the volatility is to invest inpreferreds outside of U.S. financial services, which have beensoaring over the past year. The sector has rebounded stronglyfrom the post-2008 selloff and is up more than 32 percent in the12 months ending Aug. 16, but may have run its course.

A worthy option is the Global X SuperIncome Preferred ETF, which holds non-U.S. companies such as HSBC Holdings,plc, Royal Bank of Scotland Group plc andLloyds Banking Group plc. The fund is up almost 4percent for the 12 months through Aug. 16 and yields nearly 7percent. It also costs more to manage: 0.65 percent annually.

Keep in mind that preferreds have yet another advantage thatsomewhat offsets their close correlation to bonds: They are lessvolatile than common stocks. When the S&P 500 fell 37 percent in2008, for example, the iShares preferred fund fell only 24percent.

That doesn't mean you should gorge on the high yields thatpreferreds offer and abandon common stocks. Preferred funds areheavily concentrated in the financial sector, which adds anotherlayer of diversification risk. You can always buy individualpreferred issues, but they are complicated to analyze, so youmay want to use an experienced adviser who knows how to buy themat a good price.

You'll still need to balance out the income side of yourportfolio with vehicles such as municipal, government andcorporate bonds and real estate investment trusts.

Every one of these investments can lose value in arising-rate environment, so they may still hold some nastysurprises if the economy keeps heating up and the FederalReserve starts to back off its monetary easing policy.