Recently Warren Buffett spent $8B buying preferred shares of big US companies (GE and GS).  He gets a 10% yield on his shares.  These preferred shares are different than regular shares.  You don’t hear about them very often.

Preferred shares have some advantages over common shares.  They get a higher dividend than regular shares and get preferential treatment on those dividends (the dividends of preferred shares are paid out prior to the paying of dividends to common shareholders).  Preferreds also have tax advantages; dividends are taxable at a maximum 15% rather than at ordinary income rates.

But there is a downside to preferreds as well.  It has a downside when compared to both common stock and bonds.  A preferred does not participate in any future earnings and dividend growth of the company and any resulting growth of the price of the company’s common stock.  The price of preferred stock is tied to interest rate levels, and tends to go down if interest rates go up and to increase if interest rates fall. And the preferred has less security protection than a bond issued by the company.  Preferred stockholders are behind bond holders in line for a company’s assets if it runs into a financial problem. If a company fails, money is repaid to bondholders first.

The downside when compared to common shares (preferreds do not participate in any future earnings and dividend growth of the company and any resulting growth of the price of the company’s common stock) is a big deal.  If that is true, then why would one buy these shares?  Heres why: Since 1900, preferred stocks have returned a 7.4% average annual compound rate of return. That falls short of stocks’ long-term returns of about 10%, but it tops the average 6.4% return of corporate bonds.  (But with the added income, there is added risk and downside.  Last year the bond index returned 7% while the preferred stock index fell 14%.  Last yr (2007) was the preferred stock index’s worst year since 1994.)

Many times, preferred shares are offered only to high net worth individuals.  I have a friend who has a net worth in the 8-figure range who has been offered preferred shares and purchased those shares whenever they are offered to him.  But my brokerage company has never called me offering me shares that yield 8% or more.  I read that WFC offered a preferred share in the last few months, but the cost of one share was over $100,000.  So I think the group of people to which these preferred shares are available is quite small.  But since the invent of ETFs, these preferred stocks are now available to the common man.

Three Preferred Stock ETFs to consider:

PowerShares Preferred ETF (PGX) – Has a yield of 10.16%.  Expense ratio of 0.50%.  Holds preferred stocks from JP Morgan, Wachovia, Bank of America, Wells Fargo and Citigroup.   85% of holdings are invested in Financial stocks.  The next two top sectors are Real Estate and Utilities.  Since its inception in Feb, it is down 45% compared to the S&P’s 40% decline.  That does not include dividends paid out though. It has paid out nearly 1% per month ($0.11 per $11 share per month).  The stocks bond equivalent ratings are mainly in the A rating (57%), with and some BBB (24%).

PowerShares Financial Preferred ETF (PGF) – Has yield of 12.16%.  Expense ratio of 0.60%.  Holds only preferred stocks from Financial institutions as the name suggests.  It has paid out approx 1% per month ($0.12 per $12 share per month).  In the last yr, PGF is down 43%, same as the S&P 500, but has paid out far more dividends than the S&P 500 has.  PGF holds preferred stocks from financial institutions all over the world; its largest holdings include Bank of America, JP Morgan, HSBC, Allianz, Citigroup, Barclays and Credit Suisse.  The stocks bond equivalent ratings are mainly in the A rating (71%), with and some BBB (20%).

iShares S&P US Preferred Stock Index (PFF) – Has yield of 9.27%.  Expense ratio of 0.48%.  The fund holds 89% of its investments in Financial preferred stock.  The other sectors are Health Care and Materials.  Leading holdings include Wells Fargo, JP Morgan, US Bancorp and Schering Plough.  In the last yr, PFF is down 40% compared to 43% for the S&P 500.  The stocks bond equivalent ratings are mainly in the A rating (55%), with and some BBB (26%).  It has paid out approx 1% per month ($0.26 per $26 share per month).

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