Consider preferred shares' pros, cons
By Deborah Adamson
Advertiser Staff Writer
James Cellar is a stocks and bonds type of guy.
But when his broker told him about Hawaiian Electric Co.'s trust preferred shares, the Ala Moana military retiree was intrigued even though he's never made this kind of investment before.
"The interest rate on it is 6.5 percent," said the 67-year-old investor, who bought 1,300 shares at $25.10 each. "It's a local company, it's a monopoly, so we know it won't go bust."
With the Dow Jones Industrial Average slipping below 10,000 this week, signaling deflated prospects for stocks this year, investors are on the lookout for alternatives.
One of their options is preferred stock.
Most people are familiar with common stock or bonds. A preferred share is technically a stock, representing ownership of a company, but it acts like a bond, said Bill Mann, senior investing editor for The Motley Fool in Alexandria, Va.
Investors of preferred shares are paid dividends ahead of holders of common stocks. As its name suggests, preferred shares are given preference over common stock when a company fails.
Preferred stock dividends also accrue if dividends are delayed for any reason. That's not true with common stocks. However, most preferred-shares dividends are fixed. Common stock dividends may increase over time if the company prospers.
Preferred share prices also don't fluctuate as much as common stock prices. The lower volatility translates to lower risk, but it also means that preferred shares don't have a common stock's potential to soar.
"It's a little limited on the upside," said Haywood Kelly, an editor at Morningstar, a Chicago-based equity and mutual fund research firm.
Some preferred shares are convertible into stock at a set price, which adds flexibility to an investor's portfolio.
Municipals an option
Preferred shares aren't for everyone.
Danny Alvarez, an investment representative for Edward Jones in 'Aiea, prefers to steer his clients to tax-free municipal bonds.
Triple-A rated munis of various maturities from the city and county of Honolulu, as well as the state, pay interest of 4 to 5 percent a year. Because they are free from federal and state taxes for Hawai'i residents, the payout can be comparable to taxable preferred stock, he said.
Alvarez also doesn't favor preferred shares because selling can be an issue because they're not traded in as large a volume as common stocks.
"They aren't as liquid," the financial adviser said.
But Mann contends that most small investors won't have a problem disposing of the shares because they usually buy a small amount.
Preferred shares also can be callable. If a company decides to pay them off early, it can. That means investors have no guarantee that they can hold on to the security for a long time. Hawaiian Electric's 6.5 percent trust preferred shares are callable in five years.
Look out for other restrictions. The prospectus for Hawaiian Electric's preferreds filed with the Securities and Exchange Commission says the company can suspend dividends for as long as five years. Once payments resume, investors will get the dividends owed them during the suspension.
Safety also can be an issue with preferred shares, Alvarez said. The payment of interest and principal of Hawai'i munis are insured. But your investment in preferred shares is only as good as the company issuing them, he said.
Do some checking
That's why it's important to check out the issuer's financial health, Mann said.
In general, a preferred stock rated "B" or higher is considered investment grade, or higher quality, according to The Motley Fool. Below "B" is considered a junk rating.
The ratings are provided by agencies such as Standard & Poor's and Moody's. Hawaiian Electric's 6.5 percent preferreds carry an investment grade rating from Standard & Poor's of "BBB-," the lowest of the agency's investment-grade ratings.
Check the company's free cash flow, which Mann calculates as operating income minus capital expenditures for property, plant and equipment.
If a company has a high percentage of free cash flow, say 90 percent, to pay dividends, that's a red flag, he said. It means the company is straining to make the payout. This is better: 20 percent of cash flow going towards preferreds that pay a 4 to 6 percent rate. The exception is a company that's required to pay out most of its earnings in dividends, such as real estate investment trusts or REITs.
So why buy preferred shares at all?
"It's a fairly conservative vehicle," Mann said. "If you lock in at a 6 to 7 percent return with a low level of risk, it's for everybody."
Reach Deborah Adamson at dadamson@honoluluadvertiser.com or 525-8088.
