Fasten your seatbelts -- you're about to enter the wonderful world of preferred stocks.

What exactly are preferred stocks? Basically, preferreds are a cross between a stock and bond. These stocks are called "preferred" because they receive higher priority (versus common stock) when it comes time for a company to make dividend payments.

Preferred stocks trade just like common shares on one of the major stock exchanges. They also trade under basic ticker symbols just like common stocks. Although you may hear these stocks referred to by a host of different names -- Quips, Corts, Cabcos, Pines, Toprs, Notes -- all of these are still preferreds.

Juicy Dividend Yields
It's often difficult to find solid information on many preferred stocks. In addition, because of their differing structure, preferreds can sometimes be a bit complicated. However, their juicy yields make them well worth the effort. In fact, according to the PreferredsOnline Index, which compiles data on all actively traded preferreds, the average preferred stock now offers a healthy 6.8% yield. By comparison, the 1.9% yield offered by dividend payers in the S&P 500 looks downright puny. In addition, even the 10-year "AAA" corporate bond with its 4.8% yield can't hold a candle to preferreds.

The nice thing about preferreds is that even though their share prices can rise and fall, if you hold your preferred shares until maturity, then you'll get back your capital. Like bonds, preferred shares have a face value -- meaning the price at which they were issued. Most preferreds have a face value of $25 per share. If you hold your preferred shares until they mature, then you'll get back this amount (unless the company goes bankrupt or liquidates).

Reliable Income
Preferreds are ideal for income investors who are looking for stability and above-average dividend yields. When analyzing a preferred shares, it's important to understand that their dividends are fixed to the stock's issue price, not to company earnings. As a result, preferred shares tend to be much less volatile than common shares -- preferreds don't fall as much when company earnings decline, and they don't rise as much when earnings increase. In fact, most investment-grade preferreds, issued at $25, trade in a close range between $22 and $26. 

Although that tight trading range applies to most preferred shares, we sometimes see exceptions to this general rule. Preferred shares can move sharply higher or lower as a result of a change in the underlying company's credit rating. For example, General Motors' debt was recently hit by a downgrade, causing the company's preferred shares to plummet. As a result, the yield offered by these stocks rose, giving shareholders a chance to lock in much higher yields.

When preferred share prices fall, yields rise. However, so does the risk of default. Most companies can suspend dividend payments on preferreds for up to five years if they run into major trouble. They could also default on their preferred stock obligations entirely if they go bankrupt.

Now Is The Time To Lock In Yield
Most preferred shares have long maturity dates of 30 to 40 years. As a result, they often provide investors with many years of reliable income. However, this long time to maturity also makes preferred shares highly sensitive to changes in interest rates. When rates rise, preferred share prices tend to fall. This is the exact scenario we've seen over the course of the last several months, as expectations of higher rates have driven down prices for a variety of preferred shares. With this as a backdrop, now may be an opportune time for investors to start considering preferred stocks.

Calling All Prefs!
Like bonds, preferreds are callable, meaning the issuer can buy them back from you at the issue price before they mature. Most preferreds can be called five years after they are issued. Companies usually repurchase their preferred shares during periods of declining interest rates, and they do so in order to refinance with cheaper long-term debt.

In the current environment, which is marked by rising interest rates, investors needn't be too concerned about their shares being called. Still, the longer a preferred stock's time to maturity and the closer it's trading to the call price, the better.

How Much Risk? 
Preferred shareholders get higher priority versus common shareholders when it comes time for a company to pay dividends. However, it's important to remember that bondholders receive top priority for a company's assets (ahead of both preferred and common shareholders) when a company enters into bankruptcy. In most corporate bankruptcy situations, bondholders are able to make a claim on a company's assets. In doing so, they are often able to recover at least a portion of their initial investment. By contrast, equityholders usually walk away with nothing.

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With this in mind, before you buy a preferred stock, you should make certain to analyze the underlying firm's credit quality. This will help you gauge the safety of all future dividend payments you hope to receive from the preferred stock. Ask anyone who bought Enron Corp.'s preferred shares a few years ago about the importance of staying up to date on a firm's credit quality.

Leading credit rating agencies, the most notable being Standard & Poor's and Moody's, assign ratings to thousands of firms. In doing so, they assess each particular company's default risk. Risk levels often change over time, so it's a good idea to look for the most current debt rating. Both agencies have investment-grade and speculative ratings, but each uses a different grading system.

In the table below you'll find a list of the current rating scales for both S&P and Moody's:

Taxes Take A Bite
Given the current structure of many preferred shares, only about 20% of today's preferreds qualify for the recently lowered 15% tax rate. As a result, the dividends paid by most preferreds are treated as interest income and are taxed at the ordinary income tax rate up to 35.6%. The best place for many preferreds, then, is in tax-advantaged or tax-deferred accounts such as IRAs.

For More Information
If you know the ticker symbol for a particular preferred stock, then you can easily obtain daily pricing and yield information from your online broker, as well as from a variety of free financial websites, such as Yahoo or MSN. Quantumonline.com is another free site that provides complete lists of preferred stocks with links to further information on each stock. And finally, I also provide a regular analysis of various high-quality preferred stocks in my monthly High-Yield Investing newsletter.

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