With the yields on government and highly-rated corporate bonds looking meagre, and stock markets hugely volatile, where can you get a half-decent return without taking on lots of risk?
The good news is that there's a way to get the best of both worlds: some of the protection of bonds with the juicier returns offered by high-yielding stocks.
They're called preference shares.
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What are preference shares?
Preference shares (or prefs) are a form of equity claim on a business that ranks above ordinary shareholders in terms of dividend payments and in the event of a liquidation of the company.
Now, if a firm goes bust, quite a few people remain in line to get their money before the pref holders. But what's more interesting is the dividend situation.
A preference dividend is paid out of a company's post-tax profits and is usually fixed so the downside is that, as a pref shareholder, you rarely get to participate in any dividend growth.
However, on the upside, a company cannot pay a dividend to ordinary shareholders unless the preference dividend has been paid first. And in the case of a cumulative preference share, if any dividend payments are missed, then they must all be paid before any dividends are paid to ordinary shareholders.
Are they good investments?
As with all investments, by trying only to buy securities in good businesses will youminimise risk. Here are four major points to consider:
Be wary of companies with lots of debt (with the exception of utilities).
Are the stocks cumulative? Will any missed dividends have to be paid? These types of stocks are more attractive than non-cumulative prefs where the company doesn't have to honour missed dividends.
Can the company buy them back? Some prefs can be redeemed by the company on certain dates. This is something to consider if you are looking for a long-term source of income.
Check the difference between the buying and the selling price of the shares (known as the bid-offer spread). These spreads can be quite wide and could mean that you have lost a large chunk of your return straight away.
So which ones should I buy?
There are quite a lot of preference shares available on the UK stock market. However, brokers tend not to talk much about them as the small size of the market means they can't make much money from them.
Also, a lot of preference shares are issued by UK banks and are non-cumulative. Given the precarious state of UK banks' finances, we'd steer clear of these stocks (with one exception which we've listed below).
In the table below, we list four preferred shares that you might consider buying. We have selected thembased on the size of the issue, their yields on the buying price and their relative safety.
| RSA 7 3/8% | 125 | 105.5 | 110 | 6.7% | C | No |
| Aviva 8 3/8% | 100 | 112 | 116 | 7.2% | C | No |
| Co-op Bank 9 1/4% | 60 | 119 | 123.5 | 7.5% | N-C | No |
| Northern Electric 8% | 112 | 125 | 129 | 6.2% | C | No |
We like the preference shares of insurance companies RSA and Aviva. Whilst the yields are lower then the dividend yields on their respective ordinary shares, it is worth noting that the preference dividends are much safer.
RSA's preferred dividend is covered 38 times by after-tax profits, whilst Aviva's is covered 190 times. This contrasts with dividend cover of less than two times on their respective ordinary shares.
Meanwhile, the Co-operative Bank has a very conservative business model which leads us to recommend its preference share - although bear in mind that it is a non-cumulative share.
Finally, Northern Electric is backed by a utility income stream and the financial might of its parent company, Berkshire Hathaway, so its dividend should be relatively secure.
