This asset can provide investors hefty yields at a favorable tax rate. Here’s what you should know

Published Thu, Jun 27 20242:59 PM EDTUpdated Thu, Jun 27 20243:25 PM EDT

Preferred stocks can offer investors plenty of attractive income — and do so at a favorable tax rate — but they should proceed with caution before adding them to their portfolio. Preferred stocks are hybrid assets, combining attributes of bonds and equities, and their issuers include banks and utilities . They trade on exchanges just like stocks, but they also pay investors a quarterly stream of steady income. In addition to touting attractive yields exceeding 6%, preferred stocks can also offer investors tax-advantaged income: Their coupons generally — but not always — get the same tax treatment as qualified dividends , levied at a rate of 0%, 15% or 20%. Meanwhile, corporate bond interest payments are subject to ordinary income tax rates, which can be as high as 37%. But investors who find these tax-advantaged yields tempting will need to contend with preferreds' unique risk profile. "The preferred market is very complex," said Ken Waltzer, certified financial planner and senior vice president at Wealth Enhancement Group in Los Angeles. He said these securities make up no more than 15% of his clients' fixed income allocation. "There are lots of caveats," he added. Unique features Preferreds that are offered to retail investors have a fixed par value of $25. The coupons these issues pay can be fixed for their entire term, or they can be "fixed-to-floating," meaning that after a certain period, the rate becomes adjustable. These instruments have long maturity dates — and many can be perpetual. However, they often also have a call date, which is when the issuer can redeem them. Indeed, issuers have been ramping up the number of preferred calls in recent months, liquidating more than $15 billion in the latest three-month period, according to UBS Financial Services. "The calls are predominantly coming from bank issuers whose currently callable fixed-to-floating rate preferreds are now floating and resetting at relatively high rates, sometimes over 9%," wrote Frank Sileo, fixed income strategist in the chief investment office for the Americas at UBS, in a June 21 report. When individual securities are called, investors must hunt for a replacement. Finally, holders of preferred stock are near the bottom of the list to be paid in the event the issuing company were to go out of business. Preferred investors would be paid before the stockholders, but they are well behind the bondholders in terms of priority. Due to these risks, investors shopping for preferreds ought to keep an eye on the issuers' credit ratings. For instance, ratings agency Standard & Poor's deems companies with credit ratings below BBB- to fall below investment grade. "The key thing with investment-grade rated preferreds is that though they rank lower in the capital structure versus traditional bonds, they tend to be issued by higher rated companies," said Collin Martin, fixed income strategist for the Schwab Center for Financial Research. Tapping into the market Shopping for individual preferreds takes a considerable amount of legwork. An alternative would be to look for an exchange-traded fund with a focus on preferreds, a move that helps investors avoid too much exposure to a given issuer or to a certain sector of the market. Waltzer highlighted the First Trust Preferred Securities and Income ETF (FPE) . This actively managed fund has a 30-day SEC yield of 5.82%, a total return of about 5.8% in 2024 and an expense ratio of 0.84%. Further, about 71% of its holdings have a credit rating in the BBB range. Holdings as of June 26 include issues from Wells Fargo and Barclays. There is also the iShares Preferred and Income Securities ETF (PFF) , which has a 30-day SEC yield of 6.33%. The fund has a year-to-date total return of more than 4% and an expense ratio of 0.46%. Wells Fargo and Citigroup are among the notable issuers in PFF's portfolio, but lithium producer Albemarle and renewables play NextEra Energy are also included. Though yields and total return matter, they shouldn't be the sole drivers in your decision as you shop for an ETF. Keep a close eye on expense ratios as higher fees will crimp your returns.