Dumb ideas never suffer a bear market on Wall Street. And one of the most durable of all dumb business ideas is the notion that investors have to overhaul their portfolios every time Congress tinkers with the tax laws. Now that the Job and Growth Tax Relief Reconciliation Act of 2003 has reduced the maximum tax rate on dividends from 38.6% to 15%, Wall Street is flogging dividend-paying stocks as if they were the best way to pump up performance since Viagra.
The oddest beneficiary of all this attention is preferred stocks, whose market has been shrinking until recently. Like the centaurs and griffins of Greek mythology, "preferreds" are a peculiar blend of two beasts. Like bonds, preferred shares usually pay high current income--dividends that lately pay up to 9% or 10% (that's good). On the other hand, like common stocks, preferreds have only a junior claim on assets if a company goes bust--so in a bankruptcy you could be left with nothing (that's bad).
There's no denying that the income offered by preferred stocks is tempting. With the 10year Treasury bond yielding only 3.5% and common stocks averaging a 1.6% dividend, tripling your income by loading up on preferreds seems, on paper, like a great idea. "Elsewhere, yields have just dried up," says Susan Breakefield Fulton, president of a financial-planning firm bearing her name in Bethesda, Md., that puts a portion of its clients' money into preferred shares. But as Fulton points out, most preferreds are issued by smaller, lesser-known companies. And some of those issuers are seriously obscure. Do the names Kramont Realty, NOVA Chemicals or Talisman Energy ring any bells? Still, preferred shares with reasonable yields are available from such blue-chip companies as Citigroup and Wells Fargo. Here are some pointers:
DON'T BUY YIELD ALONE. Some preferred shares are offering dangerously high yields, like Mirant's 19%. Remember, preferreds can cut or stop paying dividends entirely if the company starts to tank--and a skyrocketing yield is often the first sign of such trouble.
DON'T GET CALLED. Many preferred shares are "callable," meaning that the issuing company has the right to cancel them on a certain date if interest rates have fallen sharply. Always find out whether and when a preferred issue is callable. Insist that your broker give you not just the current dividend yield but also the "yield to call." That will estimate your income if the issue gets yanked away.
DON'T BE TAX FOOLISH. James Seidel, a tax expert at RIA in New York City, points out that in most cases you will qualify for the lower dividend tax rate only if you own your shares for at least 60 days before the dividend is paid. What's more, says Seidel, the fat yields on preferred stocks can nudge some middle-income investors past the point at which the dreaded alternative minimum tax kicks in. Check with your accountant first. --With reporting by Tara Kalwarski