David Sterman

The search for income-producing investments keeps getting harder. Uncle Sam continues to deliver paltry payouts on government bonds and notes, which has forced many investors to seek out dividend-paying common stocks. Trouble is, the popularity of these investments has pushed their stock prices up -- and their dividend yields down. The average dividend-paying stock in the S&P 500 yields just 2.5%. Even investment-grade corporate bonds offer little help. The average payout (with a duration of 2-5 years) is just 3.5%, which is well below the historical average yield of around 5%.

That's why preferred stocks are getting a fresh look from many investors. Not only do their payouts often exceed 5%, but they offer the chance of solid capital appreciation if the stock market moves higher.

Preferred stocks are a favorite vehicle for companies with steady, predictable cash flows.

If the going gets tough, these companies can temporarily defer payments to preserve cash. This differs from bonds, which come with such tight restrictions and payment terms that they can force a company into bankruptcy. Investors have come to embrace preferred stocks as well, as they proved their mettle in the economic downturn of 2008. Few companies actually halted dividend payments on preferreds, providing a once-in-a-generation stress test.

But trying to find the most appealing preferred stocks can be quite tricky. You need to assess the financial strength of the issuer and try to make a determination of which way the stock price will move. If the preferred stock offers up a 6% yield but loses 10% of its value, then you're already behind the eight ball.

That's why the basket approach holds great appeal. Rather than trying to find the best choice, why not own the group? Thankfully, a handful of ETFs -- with a combined $15 billion in assets under management -- have emerged to aid investors. Each one offers a slightly different approach, helping to cater to varying tastes.

The iShares U.S. Preferred Stock Fund (NYSE: PFF) is the big dog of the category, with $10 billion in assets and a five-year operating history. My colleague Adam Fischbaum recently profiled this fund.

Though for some investors, a heavy exposure to banks may be a detriment considering the events in Europe still have the potential to wreak havoc on this sector. 

David Sterman

David Sterman has worked as an investment analyst for nearly two decades. He is currently an analyst for StreetAuthority.com

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