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Preferred Stock

Here is how Wikipedia defines preferred stock:

Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that resembles properties of both an equity and a debt instrument and generally considered a hybrid instrument. They are senior (i.e. higher ranking) to common stock, but are subordinate to bonds.

When we usually talk about buying "shares" or investing in "the stock market", we usually mean "common" stock. Common stock is ownership in the company - pure and simple. When you own stock or shares in a company, your fortunes are tied to the fortunes of the company (or more precisely, to the perception about the future of the company).

A bond owner, at the other end of the spectrum, lends money to the company and collects interest. Bond holders usually get treated better than the owners - as is usually the case in life. A home-owner, for example, is on the hook for making regular payments on their mortgage, and the bank owns the house if the payments stop.

Preferred shares lie between common shares and bonds. They are part-ownership and part-loan. They represent a relatively low-cost way for a company to raise money, and they are used widely especially in the financial sector.

Quantum Online is one of the best sources of information about preferred stocks (and investing for income in general).

Key Considerations

When you are researching individual preferred shares to buy, here are the main things to look for:

Financial strength of the company: When you are lending money to somebody, the first thing you want to know is their ability to repay you. The financial strength of a company is usually rated by their credit-rating. Obviously the higher the credit-rating the better your chances of getting paid.
Callable or Redeemable: Many preferred stocks can be redeemed or "called in" by the company after a certain date at a certain price.
Cumulative: There are times when a company is not able to make payments on their preferred stock. As the name indicates, a cumulative preferred "accumulates" unpaid dividends for future payment.

ETFs

Many investors prefer to invest in mutual funds or ETFs instead of individual stocks or bonds. Here are a few ETFs that specialize in preferred shares if you want to go that route.

iShares S&P U.S. Preferred Stock Index Fund (PFF): This fund seeks to track the price and yield performance of the S&P U.S. Preferred Stock Index which measures the performance of a select group of preferred stocks listed on the NYSE, AMEX, or NASDAQ. It includes companies with a market capitalization over $100 million.
PowerShares Financial Preferred Portfolio (PGF): The fund normally invests at least 80% of assets in preferred securities of financial institutions such as banks and insurance companies. As you might expect, the Great Recession of 2009 took a big toll on this fund, but it came roaring back as normalcy returned to the financial markets (as I write this in March 2010).
PowerShares Preferred Portfolio (PGX): This fund normally invests at least 90% of total assets in the securities that comprise the Merrill Lynch Fixed Rate Preferred Securities index.

Investing in Preferreds

There are thousands of preferred stocks trading on various stock exchanges. You might want to buy individual preferreds by doing your own due diligence. On the other hand you could just buy one of the ETFs for a broad exposure to this asset class.

The 12% Letter has recommended several preferred stocks to invest in as opportunities presented themselves. That would be another way to go if you feel overwhelmed by the vast number of choices.

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