by Archie M. Richards, Jr., CFP^®
May 3, 2004

Want to increase your investment income? Buy the Flaherty & Crumrine Preferred Income Fund. It's listed on the New York Stock Exchange with the symbol PFD. The price is $16.11 per share. The income yield: a handsome 7.1 percent.

Flaherty & Crumrine is a California investment company founded two decades ago by Robert Flaherty and Donald Crumrine. The firm continues to be managed by Mr. Crumrine and specializes in preferred securities.

Preferred securities have some of the characteristics of stocks and some of bonds. Stocks generally have high growth potential and pay low income. Bonds have little growth potential and pay higher income. Preferreds have some of the characteristics of each. They're complicated. Unless you have detailed knowledge of them, you're wise to invest in a fund operated by a company that specializes in the field. Flaherty & Crumrine is just such a company (www.flaherty-crumrine.com).

The company's Preferred Income Fund is closed-end. This is the uncommon type of mutual fund. The more common type, like the funds of Vanguard and Fidelity, are open-end. There, the fund shares bought and sold by investors are created and redeemed on demand by the fund. The prices are always equal to the fund's net asset value per share, this being the value of the securities held divided by the number of shares of the fund held by investors.

With closed-end funds, the number of shares of the fund remains unchanged. To buy shares, you must acquire them from another investor at a price you're willing to pay. To sell shares, you must find another investor who wants to buy them at a price you're willing to receive. With the number of shares not created and redeemed according to demand, the prices of closed-end funds are seldom equal to the fund's net asset value. They stand at a premium or discount.

The Flaherty & Crumrine Preferred Income Fund usually stands at a large premium. But because of fears of rising interest rates, the price now stands at a premium of only 1.1 percent from the fund's net asset value. The worst discount in the fund's 12-year history was 12.5 percent. The major risk is the possibility of the premium turning into a severe discount. In this event, just keep holding. Undoubtedly the price will eventually revert to a premium.

As mentioned, the dividend yield is 7.1 percent. 80 percent of this is subject to federal tax at the favorable 15-percent rate.

In the long run, the fund's total return, including income and appreciation, will be less than that of a broad diversity of common stocks. But some investors needing income are willing to sacrifice some total return to obtain it.

The Flaherty & Crumrine Preferred Income Fund is leveraged. The fund borrows money to buy additional amounts of preferred stocks. The dividend income from the preferreds is used, first, to pay interest on the borrowed money. The excess dividends are paid to the fund's shareholders. Since the dividend income from the preferreds usually exceeds the interest due on the borrowed money, the income to shareholders is thereby increased.

Normally, borrowing increases risk. But with this fund, it probably doesn't. Anything can happen in the short term, but the Flaherty & Crumrine Preferred Income Fund hedges the risk of borrowing. It buys other investments (called "derivatives") which profit when interest rates rise. When short-term rates go up, the fund's cost of borrowing goes up too. But the derivative investments become all the more profitable, offsetting the higher costs.

The Flaherty & Crumrine fund managers have expertise in both preferred stocks and hedging techniques. Generally, the dividend has risen during periods of rising rates and stayed about the same during periods of falling rates.

If you need an investment that pays high income and you're willing to sacrifice some of your total return to obtain it, the Flaherty & Crumrine Preferred Income Fund is a fine candidate. It's especially promising now, while the price stands at such a small premium.