In Trying Times, Think Preferred Stocks

As an investment, preferred stocks are an often overlooked asset class. Many preferreds are "cumulative," meaning dividends accrue, even if they're not paid on schedule. Preferred stocks are mostly issued by financial and real estate companies. These companies issue preferred stock, rather than bonds, because the issue is counted as equity, not debt, on the balance sheet.

Typically, preferred shares sit between common stock and long-term debt in the capital structure. This means that in the event of a company failure, preferred shareholders will be paid after bond holders and before common stock holders.

Preferred stock is actually more like a bond than a stock. These securities pay a set dividend, usually yielding 8% to 10%. In times of stability and narrow spreads, preferred stocks act and perform like bonds. In times of high risk and volatility, they act like stocks. This summer, the risks associated with preferred stocks have risen from the bond category to the stock category due to the ongoing credit and confidence crisis.

For an investor seeking diversification, one instrument to consider is the PowerShares Financial Preferred (PGF Quote) ETF. It sports a yield of 10% and includes 34 individual issues.

Alternatively, you can buy the ETF's largest holding, the Bank of America (BAC Quote) 8.2% Preferred Series H (BAC-H). It has call protection until May 2013. At Monday's closing price of $21.95, the yield-to-call of BAC-H is roughly 11%.

Yield-to-call is calculated by taking the present value of future cash flows (dividends) plus the return of principal at the call date ($25) and discounting the those cash flows by the yield to call. Yield-to-call tells you the annualized return you will receive on your investment at today's price, assuming that the dividends you receive are reinvested at the same return rate. An 11% gain is a pretty good return -- reflecting the current perception that no financial institution is safe.