Unlike corporate bonds, which signify a creditor's position in a corporation, preferred stock signifies ownership and conveys rights to earnings and assets not granted to a common-stock holder.
The main reason preferreds are included here is that they pay a "fixed," or stated, dividend and are available to individuals. Dividends on common stock may be raised, lowered or omitted, depending on earnings. Bondholders, as creditors, have first call on earnings. Preferred-stock holders are next in line, and the residual income goes to owners of common stock.
Public utilities and banks issue a steady stream of preferreds, and industrial companies are occasional visitors to the market.
The annual dividend can be stated in a dollar amount of the par value of the stock ($10 per $100 of shares), or as a percentage of the par value (5 percent per $50 par value, which equals a 10 percent return). Most preferreds have no maturity date, but during periods of high interest rates, many are issued with call features and sinking funds that give them a limited life.
The return on new issues historically has paralleled that on similarly rated long-term corporate bonds. Consequently, an individual, in times of high interest rates, has the opportunity to acquire taxable income at an interest rate of between 10 and 12 1/2 percent on corporate securities issued by highly rated companies. Shares usually are denominated in $25, $50 and $100 units.
For corporations, the income on a preferred is 85 percent tax-free, which affords a high after-tax return. Moody's and Standard & Poor's rate preferreds according to their creditworthiness; the top four rating categories should be considered.
Preferreds are sold through underwriting syndicates made up of brokerage houses that can furnish ample information to the buyer. Many preferreds are listed on the New York Stock Exchange, which makes them easy to follow. Bond Funds
As many different types of fixed-income funds are available to the public as there are individual fixed-income investments. There are two basic types of funds: open-ended mutual funds and closed-ended unit investment trusts. Both types offer intermediate funds with maturities of no longer than three to five years and long-term funds that pay a much higher yield. Only the open-ended funds offer tax-exempt money market funds.
Open-ended funds fluctuate in size as money is received or withdrawn from over time, whereas closed-ended funds involve a fixed amount of funds. Most open-ended funds are "no-load" investments that charge no fee when shares are bought or redeemed (at the net asset value). But a management fee is charged. Minimum initial investments range from $1,000 to $2,500.
Open-ended funds, through their "family of funds" concept, offer the opportunity to learn more about market timing and investing in relative safety because the risk is spread among a number of bonds. Investors are able to move money from one fund to another within a group of funds overseen by one manager. For example, in the T. Rowe Price family of funds, an investor may move funds from the short-term money market fund to the long-term bond fund to pick up yield or take advantage of the price appreciation that occurs in longer maturities when interest rates fall. No commissions are charged for such moves.
"Unit investment trusts," on the other hand, have a fixed number of units that are issued at a certain price, e.g., 20,000 units at a price (usually about $1,000 per unit) that includes a sales charge plus accrued interest. The sponsors make a market for the units, or they may be tendered back to the trust.
The two types of instruments offer a variety of benefits, such as monthly income (which can be distributed in cash or automatically reinvested); quality investments (generally the top four categories of Moody's and Standard & Poor's); diversification (carefully selected diverse portfolios); immediate liquidity (shares or units can be readily sold); low initial investment ($1,000 to $2,500 in most open-ended funds and $1,000 per trust unit); full-time professional management (especially true of the open-ended funds), and, finally, convenience. (A variety of other services are offered; see various offering circulars for details.) Taxable Funds
Various taxable funds are available that run the gamut from high-yield income funds with portfolios of lower rated (B and BB) fixed-income securities to "moderate" yield income funds with a portfolio of Treasury and agency issues.
Also in this category are short-term money market funds, whose major objective is to preserve capital. Maturities average 30 to 45 days depending on the interest-rate outlook. These funds offer the investor a safe haven for short-term funds, liquidity, professional management and a return that currently is about 8.25 percent. Some allow access to the aforementioned benefits with initial investments of only $1,000, and most offer check-writing privileges. Tax-Free Funds
Tax-free income funds also are available to the investor, in the form of either open-ended or investment trusts. They range from lower yield, lower risk funds to higher yield, higher risk vehicles. Tax-free money market funds also are available. The various types of funds offer the same benefits as do taxables, plus the added benefit of compounding cash dividends by reinvesting them in additional shares.
The funds offer small investors the opportunity to gain admittance to the fixed-income world that previously was out of their reach. Open-ended funds such as those offered by T. Rowe Price, Fidelity and Scudder have first-class fund managers who offer a wealth of information about their products.
Sponsor-underwriters of unit investment trusts, such as John Nuveen & Co., as well as most brokerage houses offer a great deal of information on their trusts. Van Kampen Merrit Inc. and Clayton Brown are the leading sponsors of insured UITs. Many state UITs also are being offered. Zero Coupon Bonds
A popular investment vehicle that has developed since 1981 is the zero coupon bond. A ZC bond is simply a bond without a coupon that pays no semiannual interest directly to the investor. It is sold to the public at a discounted price (similar to a Treasury bill).
In essence, the discount represents a portion of the interest payment compounded on a semiannual basis at the purchase yield over the life of the bond. This means that the investor does not have to worry about the reinvestment of income, and that the stated purchase yield to maturity is exactly what the investor receives.
The Treasury market has witnessed the development of ZC bonds through three variations on the same theme. Initially, coupon bonds were physically separated, and the coupons and the body, or corpus, were sold separately at a discount price from par value (the amount of money received at maturity). Next, to overcome the possibility of the physical loss of the bond papers, receipts were created. The corpus and coupons of Treasury issues were placed in a newly established trust, and participations in the trusts were sold under feline names such as Cats, Tigers and Cougars and as Treasury Receipts (TRs). These various "receipts" were well received by investors, and the dealers profited immensely. The U.S. Treasury took notice of this profitability and began to issue its own zeroes under the acronym Strips in early 1985. The Strips issues are expected to dominate the zero market once the Treasury designates more issues for its program and also because ownership is of an actual U.S. Treasury security with all its benefits, in book-entry form (no physical delivery).
Investors have used zeroes in Individual Retirement Accounts and pension funds and to set funds aside for certain needs on specific dates. The ZC's big drawback is that zeroes are taxed each year on a portion of their appreciation even though the investor does not receive income. The math on zeroes shows that their greatest appreciation occurs in the last three to four years before maturity. The price of zeroes can be very volatile, and they make a good investment if a large decline in rates is anticipated.
There also are tax-exempt zeroes, which necessitate a different evaluation. Investors should inquire about call protection and weigh the credit of the issuer. In addition, some states may tax the appreciation of an out-of-state bond. Helpful Tips
Tip No. 1: Most of the time when you buy bonds in amounts under $100,000, they are considered odd-lots and carry higher charges. This is especially true of Treasuries. The smaller the piece, i.e. $10,000, the greater the charge. Consequently, the only way to avoid this odd-lot charge is to buy a new Treasury through the U.S. Treasury or Federal Reserve banks, or, in the case of a new municipal or new corporate bond, to purchase the securities directly from one of the underwriters at the "issue price." In the latter case, the fee is in the price. Unfortunately, you also suffer on the price when you sell an odd-lot.
Tip No. 2: If you are contemplating purchasing a new Treasury note or a bond and are wondering what its yield will be, simply look at the yield on the current or most recent note or bond of the same maturity. As a rule of thumb, the new issue will offer a yield five to 10 basis points higher than that of the outstanding similar issue. If, for example, the outstanding two-year note is returning 9.7 percent, a new issue would return about 9.75 or 9.8 percent. If the new issue did not offer a little more yield than the outstanding one, no one would purchase it.