Preferred Stocks Hold Hidden Risks

A lot of people are running around saying that preferred stocks are a great buy right now. Not so fast! Holders of Fannie Mae and Freddie Mac preferreds were saying the same thing last year and were wiped out. The risk for these investments exceeds the upside potential.

Preferred stocks pay a dividend but do not participate in upside growth or extra profits. The advantage, historically speaking, is that they paid a nice dividend yield of around 7%.

Let's get back to finance 101. Benjamin Graham and David Dodd's famous book Security Analysis lays out the hierarchy in the event of a company's bankruptcy. Bank debt is at the top of the structure. Then comes secured debt, unsecured debt, accounts payable, preferred stock, and then, last and least, common stock. Usually there is nothing left over by the time it gets to preferred and common. There are other groups in here too, but we will keep it simple.

Preferreds have taken a beating. The iShares U.S. Preferred Stock Index (PFF - commentary - Cramer's Take) ETF is down 44% from May of last year. The problem is that this was supposed to be somewhat of a safe investment. When you lose money in your safe investments, it's a double whammy.

So is now the time to buy, or is it way too early? Let's take a look. This ETF now has a 9.5% yield. Pretty enticing, considering that certificates of deposit pay about 2%. But maybe the market knows something.

This ETF has eight financials in its top 10 holdings. A few years ago when Citigroup's (C - commentary - Cramer's Take) common stock was yielding 6% and the stock was at $50, people were saying it was the buy of the year. Legendary mutual fund manager John Neff was recommending it every chance he got. The stock subsequently fell about 90% to where it is today. Someone must have known to stay away -- that's why the stock appeared to be such as buy.

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Holmes R. Osborne III is a private money manager, founder of investment newsletter StockRoyalty.com and frequent author of financial columns. He has a degree in finance from the Martin J. Whitman School of Management at Syracuse University and is a CFA charter holder. Osborne is a member of the Pacific Council on International Relations, Malibu Rotary, Business Forum International and was formerly on the board of the L.A. National Association of Business Economists. He spoke this year at the fifth annual Value Investor Conference.