PREFERRED
STOCK NEWS
Hidden
Risks of Tax-Advantaged Preferred Stocks
As we approach the
end of the year, tax considerations tend to move
to the front burner. Preferred stocks can offer
opportunities in this regard since some pay
dividends that are classified as Qualified
Dividend Income (QDI). QDI-designated dividends
are taxed at a lower rate than dividends that
are not so designated in their prospectus.
Preferred stock investors who acquire shares in
a regular income account, rather than a
tax-deferred account such as an IRA, will often
favor QDI-designated issues.
QDI Qualification
The designation
comes from the idea that if your dividends are
paid to you out of the company’s after-tax
profits, you get a tax break since the company
has already paid corporate income tax on the
money (the question of why you should have to be
taxed on money that the issuing company has
already paid tax on will forever remain a
favorite political football).
Conversely, if your dividends are paid to you
out of the company’s pre-tax revenue (such as in
the case of preferreds issued by REITs), then
your dividends are taxed at your regular income
tax rate – you, rather the company, pay the full
tax.
The tax break that you get for QDI-designated
preferred stock dividends depends on which tax
bracket you fall into. This table shows the QDI
tax rate for each federal income tax bracket.

(Sources:
Wikipedia,
Wikipedia.com; Putnam Investments,
Putnam.com)
Seven To Pick From
Of the 736
preferred stocks trading today (traditionals,
trust and 3rd-party trust, excluding ETDs), 381 are designated
as paying QDI dividends (52 percent). That’s the
good news. The bad news is that most risk-averse
preferred stock investors would probably avoid
almost all of these.
Of the 381 QDI-designated preferreds trading
today, only 198 offer cumulative dividends. And
looking for those with an investment grade
Moody’s rating drops the list down to 121. But
even at that, 73 out of the remaining 121 are so
old that they have become illiquid (daily volume
is zero since there are no sellers); that leaves
48.
Most of these 48 were issued at a time when
rates were higher than today, making redemption
of the shares highly likely. Who wants to
purchase shares and have the issuing company
call them the next day? If you are looking for
call protection of at least a year (to avoid
short-term capital gain treatment), you’re
actually down to eight preferred stocks, seven
of which have the $25 par value that most
preferred stock investors favor.
So here is the list of the seven QDI-designated
preferred stocks that offer cumulative
dividends, investment grade ratings, a non-zero
trading volume with at least one year of call
protection and a $25 par value (sorted by
Current Yield, highest to lowest).

Note that the
highest QDI-designated payer is GRX-B from
Gabelli Healthcare & WellnessRx Trust at 5.875
percent.
(Source: CDx3 Notification Service database,
PreferredStockInvesting.com)
Non-QDI Peers
Using the same
criteria as a filter, here are the top seven
non-QDI preferreds with the highest current
yield (October 27, 2015 prices).

For comparability,
I sorted these lists by Current Yield here
rather than Yield-To-Call or Effective Annual
Return so the yield values indicate the annual
dividend return (i.e. the shares are not sold
within the first year so no capital gain/loss or
reinvested dividend income is reflected in the
yield values seen here).
Notice that while QDI-designated preferreds
offer a lower tax rate than their non-QDI peers,
they also pay less dividend income to begin
with. In other words, the tax benefit offered by
the seven QDI-designated preferred stocks is at
least partially offset by the lower dividend
rate they offer when compared to very similar
non-QDI preferreds.

So at what point
is a preferred stock investor actually
benefiting from the lower tax rate offered by
QDI-designated preferred stocks?
6.95 Percent Coupon is
Break-Even
The answer, of
course, depends on which specific preferred
stocks are being compared and which tax bracket
you fall into. This next chart compares the
after-tax income produced by GRX-B, the highest
QDI payer, to the after-tax income offered by
the seven comparable non-QDI securities
(assuming a 28 percent regular income tax
bracket).

GRX-B pays $1.25
in after-tax dividend income. The break-even
dividend rate, where you start to become better
off by purchasing non-QDI shares rather than
shares of the QDI-designated GRX-B, is 6.95
percent. In other words, those holding shares of
the non-QDI HPT-D, DLR-H and CUBE-A are earning
higher after-tax income than the QDI-designated
GRX-B.
Return of Principal
On the principal
protection front, remember that issuers rarely
redeem preferred stocks that offer a coupon
below 6 percent. Public Storage, for example,
has never redeemed a preferred with a coupon
below 6.125 percent. As the highest QDI payer,
GRX-B offers a higher after-tax income than four
of our seven non-QDI peers, but at 5.875
percent, Gabelli is highly unlikely to ever
redeem GRX-B so it may be many years before GRX-B
shareholders see a return of their principal (if
ever).
Here’s another
case where the QDI-designated candidate may not
be all that it seems. This next chart presents
the after-tax income generated by these fourteen
nearly identical securities.

SCE-J from
Southern California Edison and DLR-I from
Digital Realty (which has yet to declare its
first dividend but is expected to shortly) offer
the same after-tax income at $1.14 per share.
But look at their market prices.

SCE-J offers a 5.375 percent coupon and is
selling for $26.56 per share; that’s $1.56 over
par. DLR-I, on the other hand, offers a 6.350
percent coupon but is priced $0.06 below par at
$24.94.
At 6.350 percent, DLR-I is not only much more
likely to be redeemed at some point by its
issuer (returning your principal), but today’s
buyers will realize a $0.06 per share capital
gain in the event of such a redemption.
What’s Next?
While being QDI-qualified
lowers the tax rate applied to your dividend
income, the lower coupon rate that QDI-qualified
preferred stocks offer can eliminate the tax
savings when compared to similar non-QDI
alternatives. And the higher coupons offered by
the non-QDI peers increase the likelihood of a
future redemption, meaning that the invested
principal of today’s buyers is highly likely to
be returned to them downstream.
There are currently 97 non-QDI, call-protected
preferred stocks (counting ETDS) offering
cumulative dividends and investment grade
Moody’s ratings. And 55 of these 97 non-QDI
candidates offer higher coupon rates than their
QDI-designated peers, so today’s non-QDI buyers
are much more likely to realize a future return
of their principal upon redemption.
These results will
vary, of course, depending on how the math works
out with the particular alternatives you may be
considering. But as we lean toward the end of
2015, this apples-to-apples comparison, or as
close as I could get to it, indicates that
favoring QDI-designated preferred stock for your
regular income (non-IRA) account may not be
delivering the after-tax benefit that you’ve
been counting on.
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