By Christopher M. Wright

Name: Richard Lehmann Title: President of Income Securities Advisors, Inc. Born: 1942 Experience: Lehmann, a CPA and registered investment advisor, holds an MBA from Columbia University. He taught finance and accounting at Barry University in Miami. Lehmann provides investment consulting and advisory services through a registered affiliate, Richard Lehmann & Associates Inc. He also writes a regular column on income investing for Forbes magazine, which, among other things, sets out his picks for best performing income securities (www.forbes.com/lehmann).

In his forthcoming book, bond expert and Forbes columnist Richard Lehmann tells individual investors how to select a basket of income securities that outperforms major stock indexes. “Income Investing Today: Safety & High Income Through Diversification” doesn’t pull any punches when it comes to brokers, bond funds or credit rating agencies and holds many surprises for anyone who is not hip-deep in the bond world on a daily basis. Portfolio recently sat down with Lehmann to find out more on the lure of preferred stocks and how REITs fit into his investment picture.

Portfolio: Your approach to income investing places a great deal of emphasis on preferred stock. Can you walk us through the various kinds of preferred shares available?

Lehmann: The main advantage of preferred stocks is that yields are better than bonds. Preferreds were originally created for corporations to invest their surplus cash in other companies. Seventy-five percent of the income was exempt from taxation. Since then, a variety of different instruments have been created.

Preferreds have mushroomed as a type of security to suit precisely small individual investors unless they invest through collective investment strategies such as mutual funds. The corporate bond market is shut off to individuals now because trading has been taken over by institutions, and brokers require a $25,000 or $50,000 minimum investment. Approximately 70 percent of what are called preferreds are actually bonds that are put in trust by a corporation or a brokerage house to be bought and sold on the stock exchange in $25 increments. Preferreds allow people to make small investments whereas the bond market works in $1,000 increments. Also, you can get a quotation and a firm price on preferreds, whereas the bond market has not traditionally been as transparent.

Most of the preferred issues are too small for institutions to buy, so the yields are higher than on the comparable bond because there’s not as much competition for the product. Also, there are preferred shares that are equity pieces of paper, not repackaged bonds. The dividends from those are generally eligible for the 15 percent tax treatment on Qualified Dividend Income (QDI) and should be particularly attractive to individuals in the high tax bracket.

Portfolio: Are there drawbacks for the investor?

Lehmann: It’s a less liquid market. If there are 1 million shares, only 1,000 or 2,000 shares will trade on a typical day. If you take a 5,000 or 10,000 share position, it’ll take you some time to sell, unless you’re willing to suffer the consequences of trying to unload all of it.

Some preferred issues have a suspension privilege where the distributions can be suspended for up to five years without having to declare bankruptcy if the company gets into trouble. Nevertheless, those dividends still accrue.

Portfolio: There is some debate about preferred stock. Critics say it’s issued only as a last resortwhen a company isn’t credit-worthy or performing well enough to sell bonds or common equity. Some analysts consider preferred shares below investment-grade. Others view preferred stock as just another layer in the corporate financing structure. What is your view, especially as it pertains to REIT preferreds?

Lehmann: REITs should definitely look at preferred shares for two reasons. One, it’s an ideal way for a REIT to raise additional capital without paying significantly more than what it pays common shareholders. Second, it’s a good time to be doing this because interest rates have dropped and many third-party preferreds are trading either at or above par, whereas the brokerage house that created them originally bought the underlying bonds at a discount. As these issues hit their call date, the brokerage houses have been retiring them to get up to par and the whole trust preferred market is suffering from a lack of supply.

The idea that a company issues preferred stock as an equity instrument because it can’t sell bonds is totally backward. It’s just the opposite. If somebody can sell preferreds, it’s a positive sign of their credit-worthiness.

Portfolio: In 2001, you wrote that “REIT investments look downright irresistible” at a time when the tech sector was crashing, and it was a good call. What’s your experience with REITs?

Lehmann: I’ve been involved with REITs since 1976. For many years, I was a bondholder and participated in creditor committees on REIT bankruptcies. It proved to be quite lucrative because REITs had real estate as assets and it was a highly inflationary period. As inflation increased the value of the properties, REIT values were restored.

Portfolio: In your book you speak favorably about REITs, especially REIT preferreds. Why are they so attractive?

Lehmann: REIT convertible preferreds and REIT preferreds generally have been good investments, but there aren’t many REIT preferreds right now. They tend to retire quite rapidly. The ones issued are often convertibles, and they usually have a mandatory conversion date.

The yields on REIT preferreds that exist are currently not up to the level of other preferred issues we look at. We’ll look again eventually because office and apartment REITs can raise rents to offset their debt costs if interest rates rise, unlike fixed-rate preferred issues backed by a bond. This is a judgment call as to what the interest rate outlook is.

However, REIT preferreds give investors a preference situation and have very good collateral value. REIT convertibles are particularly attractive because you can convert to common stock when the REIT grows and the dividend on the common shares gets above that on the preferred. That’s how a lot of these REIT preferred issues disappeared over time.

Portfolio: Your book talks about the income side of the portfolio for individual investors. Your model income basket outperformed the Dow Jones Industrial Average, S&P 500 and NASDAQ from 2003 to 2005. In general terms, what do you recommend?

Lehmann: I recommend a 40 percent allocation to interest-sensitive securities, such as bonds and some preferreds that are driven by long-term interest rates. That outlook is good for 2007.

Another 20 percent should be allocated to convertible preferreds, which are driven by the stock market. The yields there are quite attractive.

The energy sector gets a 20 percent allocation because it’s a fairly reliable, high-paying area and is probably going to do well over the next four or five years.

The final 20 percent allocation is for special situations and the cash needed to capitalize on them.

Portfolio: You say junk bonds ‘don’t get no respect.’ Why should investors consider them, especially when your own numbers show that they have a much higher default rate?

Lehmann: Going back 20 years, my first newsletter was about defaulted bonds. We started building databases on municipal and corporate defaults. Now I’m convinced the best rating category in terms of risk-reward is BB, just below investment-grade. Down from there, the default risk grows geometrically. If a BB bond is paying 8 percent and a similar security rated BBB is only paying 6 percent, that’s quite a difference when my studies show the default risk is not significantly different between BB and BBB. Why wouldn’t you want to take that extra 2 percent?