by Archie M. Richards, Jr., CFP^®
May 15, 2006

If you're looking for individual securities that pay high income and have low price volatility, check out preferred stocks.

Preferreds combine the features of stocks and bonds. But they trade on major exchanges like common stocks, each having its own symbol.

Most preferreds pay relatively high dividends, but they have no voting rights. If the company liquidates, preferred shareholders are paid after bond holders but before common shareholders.

Most preferreds have face values of $25 or $50 a share and are sold by the company to the public at approximately those prices. Most preferreds mature in 30 or 40 years, always at the face value.

Preferreds are offered to the public to raise capital for building the company's business. After the initial public offering, a preferred stock trades in the secondary market from one investor to another.

After a stated number of years, usually five, most preferreds are callable, meaning they may be bought back (or "called") from the holders. The customary redemption price is the face value or slightly above.

Let's say a callable preferred stock has a face value of $25 a share. It probably trades at between $22 and $26 a share.

Here's why the potential decline below $25 is greater than the increase above it:

• If interest rates rise or the company's credit quality weakens, the preferred's price may move down several points.

• But if interest rates fall or the credit quality strengthens, the possibility of the shares being called within 5 years keeps the price from moving much above $25. Like all callable securities, the potential for gain is limited while the potential for loss is not.

Naturally, if a company goes bankrupt or liquidates, its preferred stocks may be worth nothing. Sorry, there's no free lunch.

Most preferred stocks are cumulative. This means that if the company suffers a cash crunch and has to suspend its dividends, it cannot subsequently pay dividends to the common shareholders until it has paid all the dividends that were missed by the preferred shareholders.

A few preferreds are participating, meaning that if the company flourishes, the dividend may be increased by a predetermined formula. Most preferreds are not participating.

Some preferreds are convertible, meaning that after a specified date, the preferred shares may be exchanged at the holder's option for the company's common shares at a specified common price (after adjustment for subsequent splits and stock dividends). The price of the common at which the preferred may be exchanged is always higher than the common's price at the time the preferred stock is issued.

During periods when the common price is lower than the exchange price, holders don't make the exchange, because they can acquire the common more cheaply by direct purchase. But when the common price exceeds the exchange price, the exchange price becomes a bargain.

While the price of the common remains well below the exchange price, the price of the preferred is fairly stable, responding mostly to changes in interest rates. But as the price of the common approaches the exchange price, investors recognize the possibility of a bargain and lift the price of the preferred. The volatility of the preferred then begins to resemble the volatility of the common.

Unfortunately, the dividends of preferred stocks do not qualify for the maximum federal tax rate of 15 percent which applies to the dividends of most common stocks. Ordinary rates are imposed instead. Many investors put their preferreds in IRAs.

Preferred stocks come in great variety. More complicated ones have names like the munchkins in the Wizard of Oz: Cabsos, Corts, Decs, Quips, Percs, Perqs, Pines, Spurs, and Toprs.

I have no idea what those things are. Munchkin-like preferreds are specialized. Discuss them with a member of the preferred stock department of a major firm - the ones who usually deal in them. With all preferreds, take into account the trade-offs between income, appreciation potential, and risk.

If you want high income and relatively low volatility with some opportunity for growth, preferred stocks should do it for you.