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Portfolio Strategy: A good old yield play

An overlooked type of preferred stock is finding new favor with institutions, thanks to some eye-catching tax-equivalent yields.

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A good old yield play

By Eric Uhlfelder


Many investors have been focusing on the recent extension of the 2003 tax act, which will keep taxes on capital gains and qualified dividends at the reduced rate of 15 percent through 2010. But an obscure corner of the infrequently visited arena of preferred stocks offers corporate and institutional investors an even better deal than common stocks.

Dividend received deduction, or DRD, preferred stocks allow qualified investors to avoid paying taxes on 70 percent of their dividends. For the highest corporate tax bracket of 35 percent, DRD preferred dividends are effectively taxed at 10.5 percent.

Because these securities have been around for decades, one might assume that investors already have bid up the shares, pushing down nominal yields. Not so. DRDs trade in line with other retail preferreds because they also deliver qualified dividends (taxed at the 15 percent rate) to individual investors.

Corporate and institutional investors are finding that DRDs can produce some sizable returns. Tax-equivalent yields on higher rated securities are now running between 8 and 10 percent annually, estimates Steven Rubel, senior vice president of investments for Philadelphia-based Janney Montgomery Scott.

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