The search for income-producing investments keeps getting harder. Uncle Sam continues to deliver paltry payouts on government bonds and notes, which has forced many investors to seek out dividend-paying common stocks. Trouble is, the popularity of these investments has pushed their stock prices up -- and their dividend yields down. The average dividend-paying stock in the S&P 500 yields just 2.5%. Even investment-grade corporate bonds offer little help. The average payout (with a duration of 2-5 years) is just 3.5%, which is well below the historical average yield of around 5%.
That's why preferred stocks are getting a fresh look from many investors. Not only do their payouts often exceed 5%, but they offer the chance of solid capital appreciation if the stock market moves higher.
Preferred stocks are a favorite vehicle for companies with steady, predictable cash flows. If the going gets tough, these companies can temporarily defer payments to preserve cash. This differs from bonds, which come with such tight restrictions and payment terms that they can force a company into bankruptcy. Investors have come to embrace preferred stocks as well, as they proved their mettle in the economic downturn of 2008. Few companies actually halted dividend payments on preferreds, providing a once-in-a-generation stress test.
But trying to find the most appealing preferred stocks can be quite tricky. You need to assess the financial strength of the issuer and try to make a determination of which way the stock price will move. If the preferred stock offers up a 6% yield but loses 10% of its value, then you're already behind the eight ball.
That's why the basket approach holds great appeal. Rather than trying to find the best choice, why not own the group? Thankfully, a handful of ETFs -- with a combined $15 billion in assets under management -- have emerged to aid investors. Each one offers a slightly different approach, helping to cater to varying tastes.
The iShares U.S. Preferred Stock Fund (NYSE: PFF) is the big dog of the category, with $10 billion in assets and a five-year operating history. My colleague Adam Fischbaum recently profiled this fund.
Though for some investors, a heavy exposure to banks may be a detriment considering the events in Europe still have the potential to wreak havoc on this sector.
That's why Van Eck Global launched the Market Vectors Preferred Securities ex-Financials ETF (Nasdaq: PFXF) in July. This ETF holds more than half of its assets in the preferred stocks of real estate investment trusts (REITs) and electric utilities (with industrial stocks and telecom stocks accounting for another combined 20% of the fund). To win converts, this ETF sports a reasonable 0.40% expense ratio, the lowest in its category.
Will this fund hold up well if the U.S. economy significantly weakens? Well, the predominant exposure to REITs could spell trouble if another spike in vacancies hits the still-weak real estate sector. As long as the economy muddles along in the current low-growth mode, that shouldn't emerge as a concern.
Investors can also buy a basket of foreign-based preferred stocks through two other ETFs in the category. The PowerShares Financial Preferred Portfolio (NYSE: PGF) is quite similar to the iShares U.S. Preferred Stock Fund -- with one huge exception: Roughly 60% of its assets are tied up in European bank preferreds. Considering the fact that many leading European banks may need to be recapitalized as part of a broader European economic rescue package, such a focus could spell trouble for the preferreds, which may see their payouts sharply reduced, or wiped out completely.
To be sure, the 6.5% yield for this ETF, almost 100 basis points higher than the U.S bank-focused iShares ETF, is appealing, but may not be enough to compensate for the risk. The fairly high 0.66% expense ratio is another concern, eating into whatever yields the fund offers. The fact that PGF is already up 20% in 2012 seemingly ignores the considerable European economic headwinds that still remain.
Want to steer clear of European banks? Check out the iShares S&P International Preferred Stock Index ETF (NYSE: IPFF). This fund derives roughly 75% of its global exposure from Canadian firms -- most notably banks. These banks largely eschewed the lending excess of the last half-decade, and emerged in far more stable condition. It's too soon to gauge how this fund will perform. It's up around 10% since its November2011 launch, though it will need to develop a longer track-record to gain more followers and boost the daily trading volume that still averages below 20,000.
Risks to Consider: Preferred stocks aren't immune to market pullbacks, as we saw in 2008, and are best for the long-haul, thanks to their robust yields.
Action to Take --> You can also seek out preferred stocks issued directly by companies, avoiding the basket-oriented approach used by these fee-based ETFs. Your decision to purchase a preferred stock should be identical to owning the common stock. You must be convinced in the company's outlook and not solely fixated on the yield. And as is the case with any especially high-yielder, you may want to tread lightly whenever you spot a yield above 10%, as that often implies that the preferred payout is vulnerable to deferment.
-- David Sterman
P.S. -- My colleague Carla Pasternak discovered another high-yield stock that she believes is one of the best investments of the year. It's an oil and gas stock that couldn't be simpler... or more lucrative. It owns a stake in dozens of oil wells and pays out 90% of its profits to investors. And right now it's yielding 11.5%. Click here to get the name of this stock now.
David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.
This article originally appeared on StreetAuthority
Author: David Sterman