How to Lock-in Safer Yields of up to 10%

My colleague, High Yiled Investing newsletter guru Carla Pasternak, often advises subscribers to look off the beaten path for the best yields. Sometimes, the best dividends can be found inasset classes that are unfamiliar to the average investor. Such is the case with preffered stock.

Most of us know that preferred stocks pay sizable dividends, but know little else about these securities. That's a shame, because preferred dividends may be especially attractive right now. The S&P 500 Index currently yields less than 2% and high quality bonds offer about 6%, but many preferred stocks are yielding close to 7%, with some paying yields as high as 10%.

Prefferd shares are technically stock, but they behave more like bonds because they carry a fixeddividend. Dividends are usually cumulative, which means if a payment is missed, preferred shareholders will receive their overdue dividends when the company recovers, even if common shareholders get nothing. This is because preferred dividends have priority over common stock and are next in line in seniority after debt holders (bond holders) are paid.

Another advantage of preferred shares is that holders have a senior claim to the remaining business assets if the company runs into trouble and files for bankruptcy. In this scenario, common shareholders generally receive nothing, but preferred holders usually get at least a few pennies on the dollar. Preferred shares also tend to be much less volatile than common shares. This may be an advantage during a bear market but a mixed blessing at other times, since appreciation potential is generally modest.

Most preferred shares have a fixed dividend amount that is either quoted as a percentage of par value or as a set percentage. Often, dividends of preferred shares offered by banks are negotiated as a floating rate tied to a benchmark interest rate index such as the LIBOR. Companies often issue multiple classes of preferred stock, so for example, a single company may have "Series A Preferred," "Series B Preferred," "Series C Preferred" along with its common stock.

Information on preferred shares is usually more readily available compared to bonds, making them easier to analyze for investors willing to do the homework. And like bonds, preferred stocks are rated by the major credit rating agencies. Preferred shares are typically rated below a company's debt. Most preferred shares have a $25 par value that makes investing more affordable for the average small investor. (Bonds often carry $1,000 par values and require sizable minimum purchase commitments.)

Not all preferred stock is the same. Regular preferred shares have no maturity date and are issued on a permanent basis like common stock. However, most preferred shares are callable, which means that after a specified date, the issuing company can buy back the stock at or above market price. There is also convertible preferred stock which gives investors the option of converting preferred stock to common shares after a specified date. [See why my colleague Ryan Fuhrmann thinks this may be the best way to invest in GM.] This conversion feature is especially attractive for companies on a strong growth trajectory. 

A potential drawback is that preferred shares have no voting power. If you like voting your proxy every year, then preferred shares are not for you. Another concern is that not all preferred shares are treated the same at tax time. Only traditional preferred shares qualify for the 15% percent dividend tax rate. Income from trust preferred shares, which are considered debt securities, is taxed as ordinary income.

The bottom line is that preferred stock can be a great source for income if you understand the risks involved and limit your holdings to preferred shares issued by strong, reliable companies. Here are three preferred issues that offer safety and high yields. 

1. Aegon 7.25% Perpetual Capital Securities
Symbol: (NYSE: AEF)        
Yield: 7%

Headquartered in the Netherlands, AEGON (NYSE: AEG) is one of the world's largest life insurance, pension and asset management companies. The company provides life insurance, pensions and investment products through its subsidiaries in the Americas, Europe and Asia. Aegon serves some 40 million customers worldwide and generated revenue of $69 billion last year.

Aegon's 7.25% perpetual capital stock has made all dividend payments since its inception in September 2007. The current yield is 7.3%. Dividends are paid quarterly at $1.81. This security is rated "BBB" by Standard & Poor's. The preferred shares were recently trading at $25 and can be redeemed at the company's choosing for $25 a share any time after December 15, 2012. These shares qualify for the 15% dividend tax rate.

2. Telephone and Data Systems 6.875% Senior Notes
Symbol: (NYSE: TDE)        
Yield: 7%

Telephone and Data Systems (NYSE: TDS) provides wireless, local and long-distance telephone and broadband services to nearly 7.4 million customers in 36 states through its U.S. Cellular and TDS Telecom business units.

Telephone and Data Systems issued its 6.88% Senior Notes in November 2010. The notes currently trade slightly above par value at $25.24 and are callable at the issuer's choosing after November 15, 2015 at $25. Distributions are paid quarterly at a $1.72 annual rate. The notes yield 6.8% at the current price. Standard & Poor's rates these securities "BBB-". Distributions are considered interest payments and are taxed as ordinary income.  

3. Magnum Hunter Resources Corp. 10.25% Series C Preferred Stock
Symbol: (AMEX: MHR-PC)        
Yield: 10%

A few small energy companies have issued preferred shares yielding more than 9%. While their small size makes these companies a bit more risky, recent high oil prices make it easier for them to cover preferred dividend payments.

Magnum Hunter is a diversified oil and gas exploration and production company with a market capitalization of about $585 million. The company has acreage in some of the most sought-after U.S. resource plays, including the Bakken Shale in North Dakota, the Eagle Ford Shale in south Texas and the Marcellus Shale in Appalachia.

The company issued its Series C Cumulative Perpetual preferred shares in December 2009. The preferred shares were recently trading at $25.65 and can be redeemed at the company's choosing for $25 any time after Dec. 14, 2011. Dividends are paid monthly at an annualized rate of 10.25%, which is equivalent to about $2.56 annually. Based on the recent closing price, the Series C preferred shares are yielding 10%. These shares qualify for the 15% dividend tax rate.

Action to take--> My pick for aggressive portfolios is Magnum Hunter. The Series C preferred stock offers a robust 10% yield, and the company is benefiting from a strong presence in highly sought-after shale oil plays. More conservative investors may prefer the Aegon preferred shares, which carry a more modest 7.3% yield but have an investment grade rating from Standard & Poor's and Moody's.