With banks paying next to nothing on money market accounts, this is a good time to consider preferred stocks. Many are paying dividends equating to 5 to 7% yields, and some even higher. What’s more, I found five that offer significant appreciation potential, a rarity for preferreds. I’ll give you the details in a minute, but first some background.

Although traded like common stocks, preferreds are more like bonds. They represent debt, not ownership. Utilities, banks, insurance companies and others sell preferreds to raise cash. They’re called preferred because a firm must pay its preferreds’ dividends before paying common stock dividends.

About Preferreds
At the IPO, the issuing firm sets the issue price, most often either $25 or $100, and the annual dividend (usually paid quarterly), which generally remains fixed for the life of the preferred. The initial dividend yields (coupon rate) typically range from 4 to 7%. Because preferreds trade on the open market, the share prices vary with supply and demand. If the shares trade below the IPO price, the yield to new investors (market yield) moves above the original coupon rate, and vice versa.

Most preferreds are “callable” meaning that the issuer has the right to call (redeem) them at the “call price,” which is usually at, or slightly higher than the original issue price. The shares can be called at any time after the “call date.”

Usually, preferred share prices don’t move much. If originally issued at $25, preferred shares typically trade in the $24 to $26 range. However, due to current market conditions, some preferreds are trading below that range, creating capital appreciation opportunities. For instance, you would enjoy $3 per share capital appreciation if you bought shares at $22 that eventually moved back up to the $25 issue price. In that instance, you’d enjoy almost 14% capital appreciation plus the dividends that you received.

Many, but not all preferreds are rated by agencies such as Moody’s and Standard & Poor’s. For solvent companies, the ratings fall into two categories, investment quality, and non-investment quality (junk).

Five With Appreciation Possibilities
Here are five preferreds rated investment quality by Standard & Poor’s that offer substantial appreciation potential should they trade back up to their issue price.

•  Alabama Power Company 4.92% Series Cumulative (APRDM): issue price $100, recent price $78.00, market yield 6.3%, appreciation potential 28%. 

•  Axis Capital Holdings 7.50% Series B (AXPHF): issue price $100, recent price $85.00, market yield 8.9%, appreciation potential 18%. 

•  AEGON N.V. 7.50% Series B (AEH): issue price $25, recent price $20.86, market yield 7.6%, appreciation potential 20%.

•  Central Hudson Gas & Electric. 4.96% Series Preferred (CHGEL): issue price $100, recent price $87.00, market yield 5.7%, appreciation potential 15%.  

•  Pacific Enterprises, $4.40 Dividend Preferred (PET-B): issue price $100, recent price $81.05, market yield 5.4%, appreciation potential 23%.

Finding Preferreds
You can find and research preferreds on your own using Quantum Online (www.quantumonline.com), a free site. Start by using Quantum’s screener to pinpoint candidates. Get there by selecting Income Tables on the main menu and then selecting Income Securities Screening Form. Quantum provides explanatory material for each screening choice, so you shouldn’t have much trouble using it.

Once you’ve used the screen to generate a list of candidates, click on each ticker symbol to see Quantum’s description of that preferred. The descriptions look intimidating at first, but they are readable and you can click on any term with a link to see Quantum’s definition of that term.

More Needed Info
Besides for Quantum’s information, you’ll also need the current trading price, the dividend yield based on the current price (market yield), and the average trading volume to evaluate your candidates.

You can find the needed data on TDAmeritrade (www.tdameritrade.com). You don’t have to be a TDAmeritrade customer. Simply enter the preferred ticker symbol in the Quotes box. Ameritrade lists the recent trading price, the market yield based on that price, and the average daily trading volume. Compare the recent price to the issue price listed on Quantum to find your appreciation potential. Use the appreciation potential and current (market) dividend yield to determine whether the preferred works for your investing strategy.

Many preferreds that look good on paper don’t trade in sufficient quantity to allow you to easily move into or out of positions. Rule those out by avoiding preferreds with average trading volumes (10-day) below 5,000 shares.

Unlike common stocks, preferred ticker symbols are not standardized. Quantum Online and TD Ameritrade both use the same symbols and those are the ones that I listed. However, your broker may use different symbols. Using your broker’s symbol lookup function, enter the issuing company name to see a list of all preferreds issued by that company.

Due Diligence Required
Preferreds have no value if the issuing company can’t come up with the cash to pay the dividends. So, do your due diligence. As is always the case in the market, the more you know about your stocks, the better your results.

published 8/15/10