ARE PREFERREDS RIGHT FOR YOU?

Consider these stock-bond hybrids for generous dividend yields.

- DAVID MILSTEAD

As an income-oriented investor, you could look to add high-yielding corporate bonds to your portfolio.

Or maybe you could go on the hunt for stocks that pay fat dividends. Which would you prefer?

You just might prefer preferreds—preferred shares, that is.

Much like how the Osmonds were a little bit country, a little bit rock 'n' roll, preferred shares are a little bit equity, a little bit debt. Companies sell them to investors for all sorts of reasons, including their tax advantages and favorable treatment from regulators.

Their blended nature might serve you well, as well. Most preferreds are issued by high-quality companies. The shares offer payments that easily beat common-stock dividend yields and are comparable to the yields of riskier high-yield bonds. In most cases, investors can treat the preferred-stock distributions as dividends that qualify for tax-advantaged status, as opposed to interest income.

Moreover, preferreds' prices typically show a low correlation to both bonds and common stocks, making preferreds a handy diversification tool.

The first step in understanding preferred shares is understanding the capital structure of a company, which details the various ways it raised money to fund its operations. At the most basic level, companies either borrow money from banks and bondholders or they raise cash by selling stock.

Pay attention to pecking order. In a worst-case scenario of bankruptcy, there's a clear pecking order of who gets paid back first. The lenders who are most “senior” get first dibs. Then, all the rest of the debt must be covered before the owner of a common share can get anything out of the company. Rare is the bankruptcy in which the common stock emerges with any value at all.