Last week, the Federal Reserve announced the results of its “stress test” – a measurement of the soundness of major banks in the United States.

Which was initially prompted by the near-collapse of the financial system in 2008.

Four years later, the Fed’s stress test results show that banks are looking healthy again.

All but a few passed muster.

[ad#Google Adsense 336×280-IA]Most have repaid the government with money made on all of the massive bailout funds, and they’re now solvent to the point of being flush with cash.

The banks – having met stricter reserve requirements from 2008 – are chomping at the bit to get their share prices moving in the right direction.

Their solution is to pay dividends and to buy back stock.

But that doesn’t mean you should be jumping up and buying those shares with increasing dividends.

In fact, that’s not at all where you should be looking…

Look At Preferred Stocks Instead

Bank preferred stocks are where the real money can be made. Here’s how they work and why they make a great investment:

  • They’re issued by companies that want to raise capital, but without giving investors voting rights.
  • When it comes to liquidation preference, they sit between bonds and stocks.
  • They pay higher dividends than common shares, but in case things go awry, they usually have provisions allowing them to skip dividends or make them up later.
  • They tend to trade – barring severe circumstances – in a very stable range.

As for the last point, we’ll use the banking crisis of four years ago as an example. At the time, the preferred issues of many of the banks and financial companies were paying double-digit yields. Why? Because following the lead of common shares, the price of the preferred shares tanked.

In retrospect, that would have been the best time to pick the preferred shares. But there was a lot of risk involved, as there were virtually no assurances that the government wouldn’t just cancel the preferred dividends to reduce capital outflow.

Thankfully, such risks have significantly diminished since then. And bank preferred stocks – especially those of the higher-quality banks – are now a solid place to look for yields today.

These yields are two and three times that of Treasuries in some cases. And according to the recent stress test results, banks have much stronger capital structures now than they once did.

Bottom line: Even though the strong capital structure we’re seeing is largely due to the government’s injection of capital into these institutions, these dividends are the fruit of our tax dollars. And it’s time to start collecting on the loans. Preferred stocks – with lower risk but high yield – are an excellent alternative to simply chasing the dividend payouts of common shares.

Ahead of the tape,

Karim Rahemtulla

[ad#jack p.s.]

Source: Wall Street Daily