BOSTON ( TheStreet) -- Citigroup ( C), MetLife ( MET) and Public Storage ( PSA) sell preferred stock that's often overlooked by investors but can offer yields that beat those of bonds and dividend-paying stocks, says Mitch Schlesinger, chief investment officer at FBB Capital.

Preferred securities tend to lack liquidity, require rigorous credit analysis and face being retired as interest rates hover near record lows. But for astute investors, the rewards can be high. Citigroup's preferred shares, for instance, currently yield more than 7%.
Mitch Schlesinger, investment chief at FBB Capital

"As part of a broader portfolio, they are more like longer-dated bonds so you get a higher yield," says Schlesinger. "If you only buy preferreds, you're going to have a higher-yield portfolio but you're going to have a riskier portfolio because longer-dated bonds tend to be more volatile. So you have to balance the desire to get a higher yield with the knowledge that they are riskier instruments overall."

To accomplish that, Schlesinger weeds out preferred stocks by purchasing them at a discount, which offsets the risk of the securities being "called," or retired at a certain price -- typically lower. Schlesinger notes a Goldman Sachs ( GS) preferred issue that yields minus 15%, which can be attractive to some investors who believe Goldman isn't likely to retire the preferred stock.

"I think we'll avoid that one," he says. "It's always shocking to see some yields going negative on the call. It could be the market looking at the company saying they're not likely to call it, in which case people are betting it'll stay in existence and continue to pay at the higher rate, in this case 6.2% for Goldman. I prefer to buy at a discount and that offsets the risk to being called and actually losing money."

Based in Bethesda, Md., FBB Capital has more than $450 million in assets. Schlesinger says the firm has an income bias in its portfolios, although he recommends that investors only devote a small part of their portfolio to preferred securities. FBB Capital conducts its own in-house credit-quality research.

"Credit quality is paramount," Schlesinger says. "Because many times the issue is subordinate to other bonds, they tend to carry a lower credit rating. Sometimes you'll see a solid investment-grade company issuing preferreds that are rated at or close to junk status. You're really concerned with, like a bond, their ability to consistently pay the dividend on the preferred and avoid bankruptcy."

While most preferred securities are fully taxable as ordinary income, much like a bond, Schlesinger says a number are eligible for the lower dividend rate. While that rate is expected to climb slightly from 15%, some preferred securities become more favorable than others.

"We don't know what the dividend rate will be next year or even this year, really, but assuming that dividends are favored in some way in the tax structure, then some of these may be eligible for a more advantageous tax rate as well," Schlesinger says.

The pitfalls of investing in preferred securities can be a turnoff to many individual investors. Preferred stock is largely issued by banks, real estate investment trusts and utilities, limiting the exposure to other sectors. Liquidity, or the trading volume of the issue, is a "major, major factor," Schlesinger says.

"Preferred securities tend to be less liquid than other securities issued by the same companies, meaning they don't have the trading volume that you might want to see," he adds. "Subsequently, the bid/ask spread can be wider than on a straight bond, which makes them riskier. But that's why you get paid more."

The current interest-rate environment also makes investing in preferred securities like a high-wire balancing act. Lower rates increase the likelihood that a company can call the issue to lock in financing at a lower rate. In addition, the Federal Reserve is working to raise rates through quantitative easing, which will pressure prices.

Individual investors may find it difficult to perform credit analysis on their own. In that case, Schlesinger recommends the iShares S&P U.S. Preferred Stock ( PFF) exchanged traded fund, as it offers diversification and perpetual management with a distribution yield higher than 6%.

For other investors looking to take on the risk of preferred stocks for higher income, Schlesinger offers five companies where credit isn't a concern. He says many of the preferred securities will be held in accounts at the firm until they're called.

Markel ( MKL)

Company Profile: Markel markets and underwrites specialty insurance products and programs to a number of niche markets.

Preferred Stock Profile: 7.5% Callable at $25

Current Price: $26.33

Current Yield: 7.12%

Annual Dividend: $1.875

Next Call Date: Aug. 22, 2011

Maturity: Aug. 22, 2046

Schlesinger's Take: "It's quite long-dated. It has a current yield north of 7% and there is some risk that it could be called in August of next year. People need to keep that in mind. Of course, it's only about a 2% yield to the call, but relative to other bonds that would mature at that time, it's actually quite high. That's shocking to say, but that's how the market is."

Public Storage ( PSA)

Company Profile: Public Storage owns and operates self-storage facilities for personal and business use.

Preferred Stock Profile: 6.875% Series O Callable at $25

Current Price: $25.92

Current Yield: 6.63%

Annual Dividend: $1.719

Next Call Date: April 15, 2015

Maturity: April 15, 2015

Schlesinger's Take: "This is a company that has a number of preferreds and is one of the better-capitalized real estate companies. They had a recent issue that came out a little lower than I would've liked. One that was from earlier this year, the Series O, is trading at a slight premium of $26 a share. It's a perpetual preferred with a 6 7/8 dividend and close to 6% yield to the call in April of 2015. That's quite attractive compared to other bonds of similar quality."

Citigroup ( C)

Company Profile: Citigroup is the consumer banking and credit cards giant. The bank provides consumers, corporations, governments and institutions with a broad range of financial products and services.

Preferred Stock Profile: Citigroup Capital VII 7.125% Trust Preferred Callable at $25

Current Price: $24.65

Current Yield: 7.22%

Annual Dividend: $1.781

Next Call Date: Nov. 17, 2010

Maturity: July 31, 2031

Schlesinger's Take: "This trust preferred is trading at a slight discount and is currently callable. It's been callable since 2006. If it doesn't get called, you're earning over 7% annualized. But if it's called, you're still going to get an initial dividend plus some of the capital appreciation because of the discount."

"It's Citigroup and there is tons of news out on it. People have to make their own judgment on the credit worthiness of the company. We think the credit situation is improving with the government coming out of their stake and Citi selling assets. The parent company seems to be doing the right things. Their preferreds, if bought at the right price, can be pretty attractive."

Schlesinger notes that banks issuing preferred stock were previously able to count it as Tier-1 capital, although those rules may be changing.

"That was their incentive for issuing these bonds and getting them to count as equity on their balance sheet, which is really screwy but that's what the government allowed. That's going to be changing soon. That allowance is going away, so it's possible we'll see a bunch of these trust preferreds get called by the banks because they don't need to finance at these higher rates."

MetLife ( MET)

Company Profile: MetLife is a global provider of individual insurance, employee benefits and financial services with operations throughout the U.S. as well as the Latin America, Europe and Asia.

Preferred Stock Profile: 6.5% Series B Callable at $25

Current Price: $24.48

Current Yield: 6.63%

Annual Dividend: $1.625

Next Call Date: Nov. 17, 2010

Schlesinger's Take: "This is a perpetual preferred. It's trading at a slight discount of $24.48 right now. It is currently callable. Because it's trading at a discount, we view that as an opportunity. You get north of 6.5% on the yield if it doesn't get called."

Xcel Energy ( XEL)

Company Profile: Xcel Energy generates and distributes electricity and transports and sells natural gas.

Preferred Stock Profile: 7.6% Callable

Current Price: $27.57

Current Yield: 6.89%

Annual Dividend: $1.90

Next Call Date: Jan. 16, 2013

Maturity: Jan. 1, 2068

Schlesinger's Take: "This is trading at a premium but still has a positive yield to call because the call date is a little longer out. It's callable in January 2013, so just a little over two years away. It has a 2.5% yield to the call, and if it doesn't get called in that time period, you're getting a pretty nice coupon north of 7%."

-- Written by Robert Holmes in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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