2/28/2019 High Dividends, Low Taxes: A Careful Investor's Guide To Preferred Stocks

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High Dividends, Low

Taxes: A Careful
Investor's Guide To
Preferred Stocks

RYAN GARCIA FOR FORBES

William Baldwin Senior Contributor

Investing

L ooking for cash flow in a taxable account? Consider preferred stocks—but first get
a reading on their “qualified dividend income.”

J.P. Morgan Chase pays a good dividend, yielding just over 3% on

the common shares. Not good enough? You can get more. JPM has some
uncommon shares yielding well above 5%.
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2/28/2019 High Dividends, Low Taxes: A Careful Investor's Guide To Preferred Stocks
 We’re talking about preferred stock, that very unfashionable kind of equity that pays a
fixed dividend and thus acts a lot like a bond. If you need investments with a high
payout, preferreds are worth a look. And if you are investing in a taxable account, they
are worth a close look. Some of them pay dividends qualifying for a reduced federal tax
rate; many don’t.

RYAN GARCIA FOR FORBES

What follows here is a beginner’s guide to this fixed-income sector. Be forewarned that
assembling a portfolio of preferreds is a challenging assignment. It’s hard to find good
stocks, hard to get prices for them and hard to get information on that vital matter of
tax rates.

Our sherpa for this journey is Michael Livian, 47, a U.S.-born chartered financial
analyst whose European upbringing explains his fluency in four languages. He is chief
executive of the mid-Manhattan money manager Lehmann Livian Fridson Advisors.
(Forbes distributes a newsletter published by Marty Fridson.)

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Livian is an intense researcher, given to abstruse statistical analyses of coupon

rates, credit ratings and price momentum. Here’s the end point of all that data
work: Preferred stocks are a pretty good buy at the moment.

The portfolios Livian manages for income-hungry retirees usually combine common
stocks with fixed-income elements like junk bonds and preferred stocks. He’s not
adding much junk these days, he says: “From the perspective of generating income and
preserving capital today, you’re better off in cash and high-yielding preferreds.”

Preferreds from solid issuers are somewhat risky. They got mauled in the financial
crisis, but most of them kept up their dividends and the prices recovered. Except for
the favorable tax treatment sometimes available on their dividends, high-quality
preferreds are on a par with low-quality bonds. Which is to say: The preferred equity
of a class act like J.P. Morgan is about as risky as the debt of a trashy company like
General Electric.

As with junk bonds, so with preferreds: You get a high payout, an occasional hit to
principal and no growth. We’re talking about straight preferreds, by the way; the
ones that convert into common shares are an entirely different animal.

Preferred stock ranks between debt and common stock in a company’s capital
structure. That means that, in times of trouble, owners of preferred stock must be
sacrificed before bondholders suffer any damage. A company’s directors can suspend a
preferred dividend on a whim; they are, however, motivated to keep paying because
they cannot pay a dividend on the common shares in any quarter unless the preferred
holders get their full piece in that quarter.

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Sometimes trouble arrives suddenly. The preferred shares of Freddie Mac were
considered gilt-edged a little over a decade ago. When this company was bailed out by
the federal government the preferred holders were flushed down the drainpipe. Be
thankful if you did not buy preferred stock in Pacific Gas & Electric just before
California caught fire.

So the first rule is: diversify. Buy a dozen issues if you buy any.

Next rule: trade cautiously. Many preferred stocks have thin volumes. “Price
movements are idiosyncratic,” Livian says. Meaning, the ask price may bear only a faint
relation to the value of the share. He recently noted a Kansas City Southern preferred
trading to yield less than the less risky debt of the same issuer. That makes no sense.

Livian recommends that you buy or sell only with a limit order, spelling out the worst
price at which you are willing to transact. Don’t put in a stop-loss order, causing an

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automatic sale when the price dips. In a thinly traded stock, he says, that’s an
invitation to get whipsawed.

Next: beware calls. Almost all issuers of preferred shares reserve the right to redeem
them anytime after a certain date, often five years from the date of issue.
Disappointing but tolerable if the share you bought new for $25 gets taken away at
$25. Painful if you paid $26.50.

Before buying a stock at a premium over par value, look at the earliest call date and
figure out what your return would be if the issue is called and your premium vaporized.
Roughly speaking, the yield to call is equal to the coupon on the security minus the
annualized decrement to principal.

Livian goes beyond the numbers. He considers an issuer’s need for capital and the
expense it might incur to refinance a preferred with a new issue carrying a slightly
lower coupon. In some cases he is willing to make a calculated bet that a stock won’t be
called soon. He likes both the Schwab Series D and the KKR Series A, despite low yield-
to-call numbers for these issues.

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Last item on our agenda is the tricky matter of taxes. Some issuers dish out payments
that qualify to be federally taxed at the favorable rates on long-term capital gains (0%
to 20%, not counting the 3.8% Obamacare surcharge). “Qualified dividend income” is
the IRS lingo. Investing in a taxable account, you want all your dividends to be QDI.

Dividends from a bank or insurer are likely to be QDI. Dividends from a real estate
investment trust or energy partnership are very unlikely to qualify. Dividends from so-
called “trust preferreds,” which are really bonds carved up into $25 pieces, do not
qualify. Don’t own a non-QDI share unless you can stuff it into an IRA.

Livian counts 932 preferreds with enough trading volume to have meaningful price
data. Roughly half, he says, are clearly QDI issues, with tax treatment of the rest either
unfavorable or murky. Issuers are almost always mum on this point, perhaps because
they can’t be sure of how their payouts will be treated in any given year until the
corporate tax return is complete. I expect all of the stocks in the table to be paying QDI
in 2019, but there are no guarantees.

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Getting info on preferreds and funds that own them is a chore, beginning with the
tickers. The share that goes by JPM-PC on Yahoo Finance is JPM.C on Google Finance,
JPM/PC on Fidelity and JPM/PRC on Schwab. Fidelity doesn’t tell you when the
security can be called; Schwab has an answer to that question but it doesn’t agree with
what’s on J.P. Morgan’s investor page. Morningstar reports that the portfolio of the
Invesco Preferred ETF (PGX) has an average credit rating of AAA, which is quite at
variance with what Invesco says.

A Bloomberg terminal gives you all the statistics you might want on a preferred stock.
If you don’t have one of those things, be creative. Take a peek at the financials for a
fund that owns preferreds. For call dates and credit ratings, the portfolio page that
Invesco publishes for PGX is quite helpful.

The annual report for Flaherty & Crumrine Preferred Income (PFD) conveniently flags
issues that have been paying QDI. The Invesco Financial Preferred ETF (PGF) tracks
an index for which QDI is a criterion, so, if you don’t mind a bank-heavy portfolio, you
could copycat its big positions and be reasonably assured of collecting QDI.
QuantumOnline has a rich data set (free with registration) that includes a QDI screen.

Is all of this headache worth it? I think so. Net of damage to principal when a
premium-priced stock is called in or your utility inadvertently torches the
countryside, you can expect a return of 5%. Allow for a 15% federal tax (relevant to
most of the people reading this paragraph) plus a 3.8% surcharge (for the ones with
income over $250,000) and you’re left with 4% and a fraction. That beats the not
quite 3% you can get on the Vanguard Long-Term Tax-Exempt Fund.

Or you could buy a fund. Less work, but you’ll lose a quarter of a point or more to fees
(offset in some cases by income from securities lending). Another drawback to a fund is
that it may throw some non-QDI income your way.

William Baldwin Senior Contributor

I aim to help you save on taxes and money management costs.

I graduated from Harvard in 1973, have been a

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journalist for 44 years, and was editor of Forbes magazine from
1999 to 2010. Tax law is a frequent subject in my articles. I have
been an Enrolled Agent since 1979. Em...
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