Hidden opportunities in preferred stock.

The complex preferred stock market is difficult to gauge--which provides calculating investors with outstanding returns.

Investors are scrambling to maximize returns in today's low-interest-rate environment. However, these income-oriented investors may be missing an opportunity right under their noses: the preferred stock market, which offers equities issued by America's largest corporations, insurance companies, and utilities.

One of the preferred market's biggest attractions is that so few people understand it. Imperfect investor knowledge creates an inefficient market--and therefore, overall returns that can exceed those of either bonds or common stocks. Tax benefits also are a big attraction of preferred stocks. A little research can create a lucrative opportunity for rounding out a well-balanced portfolio.

The U.S. has the only developed market for preferred stocks, and traditionally, utilities were the largest issuers. (Preferred stock allows utilities to raise capital for construction without hurting their debt-equity ratios and, therefore, their debt costs. Utilities that issue preferred stock also receive a number of tax benefits, which vary from state to state.) In the last three years, however, banks and other financial institutions have become the biggest issuers of preferred stocks, mainly because of new federal primary capital requirements. Banks now are allowed to count preferred stock as core (Tier I) capital--which helps improve their capital ratios. Most recently, Bank of America, Citicorp, Chemical Bank, and Chase Manhattan have been major issuers of preferred stocks.

Corporations jumped on the bandwagon during the acquisition sprees of the 1980s--for instance, RJR Nabisco created a substantial issue of preferred stock during its merger and is moving to issue more, partly to compile a war chest to finance future acquisitions. Issuing preferred stock rather than debt allows companies to improve their debt-capital ratio and possibly improve their debt rating the next time they issue bonds.

While corporate issues have dwindled since the 1980s, preferred stock now appears to be undergoing something of a resurgence among corporations. Since the end of 1991, GM, Ford Motor Co., and IBM each has issued 44 million or more shares of preferred stock--creating the three largest issues of corporate preferred stock on the market. This trend may continue, as blue-chip companies seeking greater appreciation than offered by their common stock turn to less traditional financing in the preferred market. In addition, corporations without income-tax liability have an incentive to issue preferred stocks--while improving their capital structure, there's no disadvantage to paying preferred stock dividends (which are paid after taxes) versus bond payments (a pre-tax expense).

SHOULD YOU BUY?

Compared to bonds, preferred stocks offer tax advantages to certain investors that make them worthwhile.

Under the current tax law, dividend income to any incorporated investor is 70 percent tax-exempt. Therefore, a corporation with a 34 percent tax rate pays only $10.20 on every $100 in preferred stock dividends--versus $34 in tax on every $100 in bond coupon payments.

Because of this tax advantage, bonds generally have higher yields than preferred stocks. The exceptions are offered by equity issuers with weaker credit ratings, which must offer an additional risk premium to entice investors. (Bonds have priority over preferred stock if the issuer is forced to liquidate.) For example, Public Service of New Mexico's preferred stock has nominal yields of 10.25 percent to 10.5 percent, which is 25 to 50 basis points more than offered by Public Service's long bonds.

The majority of preferred stock purchasers are institutions, including large corporations that need to shelter excess cash against taxes. Insurance companies are the biggest institutional buyers of preferred stocks, largely because of special accounting rules that allow these issues to be carried at cost, rather than at market value. Individual investors may purchase single issues or make their investment through preferred stock mutual funds. Most corporations and smaller insurance companies work with money managers and brokerages that specialize in preferred stock issues.

Preferred stocks can make a valuable contribution to an institution's investment portfolio. For example, a medium-sized insurance company established a preferred stock "dividend-capture program," under which it purchased issues near their ex-dividend date and sold issues that were ex-dividend and had been held for 45 days. As a result, the company could receive a maximum of seven or eight dividends per year--rather than the usual four dividends paid by an individual preferred stock. From January 1, 1992, to December 15, 1993, this company realized an annual return on investment of 11.4 percent on an average investment of $37.2 million. This is obviously a respectable return in a low-interest-rate environment.

Pension funds and individual investors have been less enthusiastic about buying preferred stock. Neither investor is eligible for the tax benefits of preferred stock ownership versus bonds--so any investment in this type of stock must stand on its own risk-return merits. Individuals pay taxes on all the dividend income from a preferred stock, while institutions pay taxes on only 30 percent.

SELECTION CRITERIA

The most important criterion in deciding to buy a particular preferred stock issue is the issuing company's underlying credit. How are the shares rated? What's the issuer's long-term credit trend? If an issuing company has credit problems, risk-averse investors should stay away from its preferred stock.

Investors also should examine the call protection offered by a preferred issue. Most are non-callable for five years, which protects investors for that length of time if interest rates drop after the stock is issued. If the stock becomes callable, and market rates are substantially lower than the preferred stock's dividend rate, the issuer is likely to "call" or retire the stock.

In addition, issuers should look at how the preferred stock is priced in relation to similarly rated issues in other industries. There's no point in overpaying. Examples of popular preferred stocks that meet these criteria and were issued in the first months of 1994 include Chemical Bank and Chase Manhattan.

Because of higher growth levels offered by international markets, many investors are attempting to increase returns by investing in foreign companies and U.S. multinationals. These investors also may be interested in preferred stocks issued by foreign companies. Barclay's Bank and the Royal Bank of Scotland are two foreign companies that have issued preferred stock in the U.S. because of a tax agreement between the U.S. and the U.K. Both the issuing company and individual investors receive a tax credit for preferred stock issues.

Finally, some investors are discouraged by the difficulty of finding industry experts to guide them through the preferred market. A relatively small number of brokerage firms specializes in these stocks, because the market for each preferred stock is comparatively small, and most preferred stocks are not listed on stock exchanges. Of course, those inefficiencies also help create disproportionate potential returns in the preferred stock market. For that reason alone, preferred stock can be a valuable part of a well-rounded investment portfolio.

PREFERRED PICKS

            NYSE      Call        Call     Price
Issue       Symbol    Date        Price    4/15/94    Yield

Chemical Bank
$7.50       CHL+K     6/1/98      $25      $23-1/4    8.09%

Chase Manhattan
$8.40       CMB+M     3/31/98     $25      $24-3/4    8.46

BankAmerica
$7.875      BAC+M     12/15/97    $25      $24        8.33

McDonald's Corp.
$7.72       MCD+E     3/1/98      $25      $25        7.79

Federal Home Loan Bank
$6.72       FRE+A     9/30/98     $25      $24-7/8    6.73

GAUGING THE FIELD

Preferred stock is a class of capital stock that pays dividends either as a percent of par value or a specific dollar amount. Preferred stock dividends usually are paid quarterly. Generally, preferred stock does not have voting rights, and dividends are cumulative. Preferred stocks are senior to common stock, but junior to first mortgage bonds, notes, or debentures. If the issuer stops--then resumes--paying dividends, it must pay off all preferred stockholders before it can resume paying common stock dividends.

Time to maturity is the single largest dictator of a preferred stock's return, although (like bonds) quality rating also plays a role. The types of preferred stock include:

Perpetual preferred, the most common variety, does not have a maturity date. Yields are higher because of a greater level of market risk (attributable to economic factors) and interest-rate risk (the chance of an unfavorable change in interest rates) over the life of the stock.

Sinking fund issues have a stated maturity or date by which the issuer must repurchase the entire issue. Usually, a sinking fund begins repurchasing stock within five years from the date of issue, retiring a fixed number of shares each year. Sinking fund preferred stocks with 25- to 30-year maturities offer the highest yields.

With adjustable rate issues, the dividend is reset each quarter based on a pre-established basis-point spread from a benchmark U.S. Treasury rate. These issues have existed only since 1982 and are particularly popular with investors when interest rates are climbing.

Auction rate preferred stocks are actually money-market instruments, since the dividend is reset every 49 days through a Dutch auction. Because of their short maturities and money-market characteristics, auction rate preferred stocks offer the lowest yields--roughly 2 percent to 3 percent.

Paul Maloney, senior vice president of Rodman & Renshaw's preferred stock department in Milwaukee, has more than 15 years of experience in institutional preferred stock sales and trading. His group of six specialists trade preferred stocks issued by utilities, banks, and other corporations for several hundred accounts nationwide.