FIXED-INCOME WATCH // RICHARD LEHMANN

Why you should prefer preferreds.

AT LEAST ONCE A YEAR I review the market for preferred stocks to remind income investors that there is an alternative to bonds. Bonds currently have an interest rate cloud hanging over their future, yields are already meager and in the case of junk bonds high risk is a big worry.

Think of preferreds as the Rodney Dangerfeld of investments; that’s what makes them such a good buy. They cover seven varieties of securities that can be either debt or equity. They are particularly suited for individual investors because they’re often too small for institutional investors who deal in million- dollar positions. However, when you ask your broker about them, you usually get a negative response. Most brokers don’t understand these securities well enough to recommend them. This is compounded by the fact that many frms ban their sale by rank-and-fle brokers because most preferreds are rated below investment grade. No brokerage frm wants to get tied up in client litigation in the event that one of those preferreds ends up in a bankruptcy. If you insist on investing in preferreds, many advisors will simply steer you into mutual funds, for a fee of course.

My advice is to ignore your broker and selectively buy preferred stocks directly. All the news about Fed rate hikes and their efect on long-term securities is greatly exaggerated. The hikes afect long rates only if our central bank begins selling of Treasurys and mortgages, and this is not even under discussion. When rate hikes come, they will afect short-term paper, probably in one or two 25-basis-point hikes.

Preferreds that pay 5.5% to 7.5% are likely to appreciate in 2015 because long rates will be driven down by the rising value of the dollar. That hurts international companies’ earnings but brings a food of carry trade and foreign money into the U.S. to invest for yield and currency gains. In fact, the real fear today is that declining oil prices will induce defation, which also drives interest rates lower.

It is important to diversify your preferreds. Start with CHS INC. 6.75% PERPETUAL PREFERRED (CHSCM, 25), yielding 6.8% with no call until Sept. 30, 2024. I have been recommending securities of this unrated but well-run global agricultural cooperative for a decade. It’s getting hard to fnd such high coupons with long call protection, and this one is eligible for the 15% tax rate on qualifed dividend income (QDI).

For those wanting an investment-grade issue, look at RENAISSANCERE HOLDINGS, a Baa2/ BBB+/BBB-RATED global property and casualty insurer. It has a 5.375% NONCUMULATIVE PERPETUAL PREFERRED (RNR E, 24) yielding 5.6% (QDI), callable in June 2018. A comparably rated bond currently yields less than 4%. Financial institution preferreds make up a large amount of the market, and here I recommend CAPITAL ONE FINANCIAL. This medium-size fnancial services company has a Qdi-eligible 6.25% PERPETUAL PREFERRED (COF C, 25), which is rated BA1/BB and callable in September 2019.

REITS are also a preferred play. I like DIGITAL REALTY TRUST, which owns data centers in 130 locations worldwide. Its 6.625% SERIES F PREFERRED (DLR F, 26) yields 6.5% and is rated BAA3/BB+. If you want a REIT with an equity play along with a preferred yield, look at EPR PROPERTIES, one of only a handful of attractive convertible preferreds. Its 9% PREFERRED (EPR E, 33) yields 6.9%, which is well above the 4.1% yield on the stock. Conversion won’t happen until the common stock reaches $83.11, up from a current $64. That translates to a preferred redemption at $37.50, which is not a bad call-away premium.

Now for my FORBES 2014 scorecard. Last February I began the year recommending 14 securities that, along with my other picks, returned a handsome 11.9% for the year, nearly doubling a benchmark return of 6.3%. One of my biggest losers was gold (GLD), recommended as a hedge against surprises. The surprises came late in the year, but gold has almost fully recovered so far in 2015 and looks better with each passing day.

ALL THE NEWS ABOUT FED RATE HIKES IS GREATLY EXAGGERATED