Preferred stock blends attributes of both and could be a great addition to a portfolio. But what is preferred stock exactly and why does the mutual fund structure make perfect sense for the esoteric security type? How can you use it in your portfolio? Read on to find out.

Be sure to also see the 7 Questions to Ask When Buying a Mutual Fund.

While quirky and ignored by most investors, preferred stock can be a great bet for the income side of your portfolio. As we said in the opening, preferred stock is a security-type that blends both debt- and stock-like attributes. Preferred stock trades on an exchange, which provides daily liquidity just like regular equities. The kicker is that these shares include priority over common stockholders on earnings and assets in the event of liquidation/bankruptcy. This is second only to bond and other senior loan holders.

As for the bond side, preferred shares have a fixed guaranteed dividend amount, which is paid out before payments to common stockholders. These payments are often much higher than the regular dividend payments on the firm’s common shares. Also making preferred bond-like is that they have a par value. Just like bonds, these shares are issued at a certain amount – usually $25 or $1000 per share. Due to market forces, they can trade at premiums or discounts to that amount. Like bonds, preferred stocks come with a maturity date, which means the issuing company can retire the security at par for investors.

The cons for the share structure are that investors lack voting rights—which are granted to common stockholders-and there is capped upside due to callability at its par value. Common shares can essentially go up forever.

See also Beginner’s Guide to Bond Mutual Funds.

Even given those small cons, preferred stock can be a great position to have in your portfolio. The most obvious upside is income potential. With yields in the 5% to 8% range, preferred securities can be the cure for low interest rates. They can also be a powerful total return tool. Remember, these shares can trade for below their par value. By scooping up shares below par, investors can profit when they are called. Buying a preferred share at $20 and having it called at $25 is an easy 25%. And that’s not including the dividends you’ll collect.

The problem with preferreds for retail investors is that it can be downright costly and difficult to purchase individual shares. Many preferreds trade just a few thousand shares a day and can be research intensive, as some firms have several share classes – each with their own dividend payment structures. That is, if you can find info on individual preferred shares. Most major financial websites, blogs and online media only give ticker, trading volume and yield information.

By buying preferred stock through a mutual fund, retail investors leave the hard work to the professionals, who can research and find the best yields as well as candidates for capital gains. Additionally, by buying a preferred stock mutual fund, investors are able to spread their capital among a multitude of individual issues rather than just buying one or two preferred stocks. This helps in the event of a potential blow-up.

Additionally, by using a mutual fund to own preferred stocks, investors can get a break on the tax front. Unlike common stocks, not all preferred stock dividends qualify for the lower tax rate – currently at 15%. Investors—given the lack of available research—could be setting themselves up for a nasty tax bill if buying individual preferred stocks. Many preferred stock mutual funds state in their mandates that they will seek securities that qualify. Also, many managers can and do seek to minimize the effects of capital gains when shares are called.

See our 7 Essential Tips for Mutual Fund Investors.

Cohen & Steers Preferred Sec & Income A (CPXAX): While CPXAX is relatively new—launching in 2010—it has managed to earn a three star rating in that time as well as amassing nearly $2.9 billion in assets. The actively managed fund’s mandate is to provide a high level of income and gains. Again, it’s managed to deliver on that promise with a 10.48% total return since its inception.

Expenses for CPXAX are lower than the category average at 1.10%. However, the fund does charge a 3.75% sales load for A shares. The minimum investment in the preferred stock fund is $1,000.

Principal Preferred Securities A (PPSAX): PPSAX is the oldest mutual fund dedicated to preferred securities – first launching in 2002. It’s also one of the largest funds in the sector. Management tends to trade down the credit ladder and run the entire gamut of preferred stock types in order to pick up a few more percentage points of yield. About 90% of its portfolio is rated BBB or BB. This creates a juicy 5.01% yield.

Expenses for PPSAX run 1.07% and there is a 3.75% front-end load on A shares.

Nuveen Preferred Securities A (NPSAX): For investors looking for some international flair to their preferred stock portfolio, NPSAX offers exposure to “Yankee” preferreds issued overseas. The Yankee Bond Market consists of U.S. dollar-denominated, publicly issued debt of non-U.S. corporations, foreign government debt, and supranational debt. About 33% of NPSAX’s portfolio is in Yankee preferreds.

That focus on some international issuers has given the mutual fund a slight edge in the returns department. NPSAX managed to produce an 11.9% total return over the last five years. Currently, the fund yields 4.86%. Expenses run 1.07% and come with a 4.75% front-end load.

For investors, the stock/bond hybrid known as preferred stock can be a great source of income and capital gains in their portfolios. However, they can be difficult to analyze and research. Mutual funds make it easy to diversify and gain a high total return from the asset class.

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