In a barren income environment, assets such as preferred stocks and the Principal Spectrum Preferred Securities Active ETF (CBOE: PREF) standout, but it’s important investors know what they’re getting into here.

Preferred stocks are a type of hybrid security that shows bond- and equity-like characteristics. The shares are issued by financial institutions, utilities, and telecom companies, among others. Within the securities hierarchy, preferreds are senior to common stocks but junior to corporate bonds. Additionally, preferred stocks issue dividends on a regular basis, but investors don’t usually enjoy capital appreciation on par with common shares.

“Preferred stock is a rather unique type of equity that might best be described as a hybrid investment vehicle combining characteristics associated both with bonds and common stock. Like bonds, preferred stocks tend to appeal to income-oriented investors seeking a steady, predictable stream of cash,” according to Seeking Alpha.

PREF Works

Additionally, with PREF, investors can diversify their portfolios. Hybrid securities have exhibited lower correlations to traditional stock and bond strategies, offering a way to diversify investments and potentially mitigate volatility.

PREF offers high monthly income by targeting preferred securities that have historically offered higher yields than similarly rated bonds, allowing for a solution to diversify income streams. Preferred securities may also pay qualified dividends, which are taxed at a lower rate than ordinary income.

Like common stock, preferred stock is issued by a company and traded on an exchange. Preferred stock prices can fluctuate, but most of the returns from preferred stock come from dividends. Unlike common stock, preferred stock dividends are predetermined and paid at regular intervals. These dividends are paid in full before any dividends are released to common stockholders.

“Those benefits understandably appeal to many income-oriented investors, but there are some significant downsides to investing in preferred stock that must also be taken into consideration when looking to initiate or add to a position,” according to Seeking Alpha. “As I mentioned above, preferred stock almost never offers investors significant capital appreciation. Thus, if you’re seeking growth, you’d best look elsewhere. Another drawback to preferred stock that investors may want to consider is the very real possibility that a company will issue a share call. Like bonds, preferred stock generally has a maturity date set decades in the future.”

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.