Should You Prefer Preferreds in 2013?

Investors have been looking for income wherever they can find it lately. But sometimes, the quest for higher yield takes you into territory where the returns don't justify the risks -- or where you'd be much better off going ahead and taking on more risk for proportionally greater chances of profits.

One area that has drawn a lot of investor attention over the past year is preferred stock. With preferreds enjoying huge gains in 2012, many performance-chasing investors are looking for further success from the asset class in 2013. But as with many other high-income investments, preferreds carry some risks that you need to be aware of before you commit your cash. We'll take a look at those risks below, but first, let's bring everyone up to speed on exactly what preferred stock is and how it differs from the ordinary common stock that most investors are more familiar with.

The scoop on preferred stock
Preferred stock confuses beginning investors because its name is misleading. What makes a stock preferred isn't whether it's a smart investment but rather where it lies within a company's capital structure. Most of the time, companies have two main tiers of capital, one they obtain by issuing bonds and the other from making offerings of equity. Bondholders have fixed return potential, as the payments they receive are strictly defined by the terms of the bond, but they also enjoy the highest priority to get repaid no matter what happens to the company. By contrast, equity shareholders have potentially unlimited returns, but they also have to go to the end of the line if the company goes under and often come out with nothing.

Preferred stock lies in the middle of the capital structure. Like bonds, preferred stock typically pays a fixed interest rate and has priority over common shareholders, in that preferreds are entitled to get a certain value back before the common receives payment. Moreover, preferred dividends have advantages that common-share dividends lack, again depending on the terms of the preferred. But when it comes to growth potential, preferred stock doesn't look like stock at all -- it tends to move with interest rates rather than with a company's fundamental prospects.

So what's the risk?
For many investors, the idea of getting solid income without the volatility of common shares may seem like a trade-off worth making. For instance, investors in Annaly Capital and American Capital Agency common shares have had to deal with the uncertainty involved with mortgage REITs, but their respective preferred shareholders have seen much less substantial losses in recent months as the uncertainty hasn't yet posed a major threat to investors higher up on the capital structure. Moreover, with popular preferred ETFsiShares S&P Preferred and PowerShares Financial Preferred both having seen gains of 15% or more in the past year, it's hard to argue with their past success.

Yet the problem with preferreds is that in the current environment, it'll be tough for the securities to continue producing attractive gains. On one hand, if the companies that issue preferreds continue to do well, then you would have gotten better returns from the common shares. On the other hand, though, with new signs that the Federal Reserve could raise interest rates sooner than expected, preferreds could see downward pressure from higher rates. Even though many preferred stock issues pay higher yields than their common counterparts, especially dividend-challenged Bank of America , the dividend income may not be enough to make up for capital losses in a rising-rate environment or for missed opportunities if the bull run continues.

Make the right call
Investors in preferred stock have seen some huge gains in recent years, but the good times may not last forever. Don't assume that the rewards you've seen from preferred stock will continue, as much of the gains have come from the recovery in financial companies from the brink of ruin. Instead, consider other investments with better risk profiles and that haven't yet paid off for investors quite as well.

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The article Should You Prefer Preferreds in 2013? originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool owns shares of Annaly Capital and Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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