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. These instruments, he says, are “always a smart play for qualified corporate and institutional taxable accounts.”

Lack of widespread investor familiarity with preferreds in general and with DRDs in particular accounts for such high yields. “There are qualified institutional investors who opt for fully taxable preferreds and bonds because they only focus on the dividends being paid,” observes Rubel. These buyers miss out on “the significant aftertax benefits, which won’t show up until later.”

Of course, DRDs carry their own risks. Like all dividend-yielding preferreds, DRDs are lower down the capital structure than bonds, which means companies can skip their dividends without going into default. Newer issues, like last year’s MetLife 6.5 percent preferred series B, have precise triggers — such as a net loss over the trailing four quarters — that halt dividend payment. Another element of uncertainty: DRDs don’t mature, leaving their value squarely up to the marketplace. Getting out of a position in a rising rate environment could be costly.

For these reasons, credit rating agencies typically rank preferreds one to two notches below the senior unsecured debt of the same issuer. “But when you’re dealing with high-investment-grade companies,” explains Martha’s Vineyard–based consultant Daniel Campbell, former head of hybrid capital securities at Merrill Lynch & Co. and Deutsche Bank, “the chances of management missing a preferred payment are about the same as its failing to pay interest on a senior bond, since the implications on the company’s corporate rating and image would be comparable.”

This belief is the basis of a strategy that L. Phillip Jacoby IV, co–portfolio manager at Stamford, Connecticut–based Spectrum Asset Management Corp., the subadviser for Nuveen Investments’ preferred funds, calls trading down the capital structure. “The best way to access higher yields,” Jacoby says, “is to look for income securities of highly rated companies that have less capital protection in case of default, instead of investing in higher-paying senior securities of struggling firms.”

Most preferreds are nonmaturing perpetual securities, although they may be called by the issuer five years after they come to market. Thus analysts generally compare them with 30-year bonds.

On August 15, Goldman’s 6.125 percent coupon, single-A-plus-rated bond due in 2033 was trading at 97 and yielding 6.31 percent. The bank’s single-A-rated DRD series B preferred was trading at 25.41 and yielding 6.10 percent. For qualified investors in the 35 percent tax bracket, however, the pretax equivalent yield of the preferred was 8.40 — fully 209 basis points above the bond yield.

“Regardless of where we are in the interest rate cycle, this tax-equivalent spread between DRDs and bonds is pretty typical,” says Rubel.

Until the 1990s, DRDs were the most common form of preferred stock. Because most preferreds don’t mature, proceeds from such issues are considered tier-1 capital for financial institutions and help them meet capital requirements.

The popularity of these instruments waned, however, after the 1995 introduction of trust preferred securities, or TPSs, which offer tax advantages to the issuer rather than the investor (dividend payments are tax-deductible). The following year the Federal Reserve Board ruled that TPSs counted as tier-1 capital, quickly making them the favored form of preferred financing.

Barry McAlinden, preferred stock strategist at UBS Financial Services, reports that TPSs now make up 42 percent of the $250 billion of preferreds outstanding — the largest segment of the market. DRDs represent only 14 percent. Preferred wrapped senior notes and foreign preferreds each have 17 percent of the market, while preferreds from real estate investment trusts account for most of the remaining 10 percent.

Even if DRDs represent a smaller piece of the preferred pie, canny investors can still spot value. “Insurers, utilities and industrials are key investors in these securities because they are able to benefit from DRDs’ superior risk-based returns,” according to Donald Crumrine, chairman of Pasadena, California– based Flaherty & Crumrine, which manages $2.8 billion in preferred funds and advises an additional $1.2 billion in private accounts largely invested in preferreds.

Flaherty & Crumrine’s closed-end Preferred Income Fund has a current yield of 6.02 percent. Despite rising rates, the fund has held up well so far this year, climbing 2.22 percent through mid-August. Over the past five years, it has generated annualized returns of 10.20 percent, a whopping 7.09 points better than the Standard & Poor’s 500 index. And that’s before the tax advantages provided by DRDs, which make up 82 percent of the fund’s portfolio.

One strategy to counteract losses from today’s rising interest rates is to invest in floating-rate preferreds. In March 2005, Nuveen launched its closed-end Tax Advantaged Floating Rate Fund. “While the fund’s underlying assets can be impacted by changes in credit spreads between preferreds and Treasuries,” explains Spectrum’s Jacoby, “the ability of these preferreds to periodically adjust their dividends to market conditions should help prevent capital erosion.”

So far this seems to be the case. The $275 million fund, with 80 percent of its assets invested in DRDs and a current yield of 5.53 percent, was up 10.81 percent through the end of July. Jacoby recently put 2 percent of the fund in a new single-A-minus-rated Morgan Stanley DRD floating-rate preferred that pays 70 basis points above three-month LIBOR. “Its initial yield was 6.19 percent,” says Jacoby, “and equally attractive is that the yield can never drop below 4 percent.”

Gregory Phelps, co–portfolio manager of John Hancock Funds’ nine preferred funds, with $4.9 billion in assets, explains that institutions like preferred closed-end funds for the diversity of their portfolios, monthly income and leverage, which juice up returns. “Funds can leverage up to 50 percent of their assets at a rate that’s cheaper than most institutions can borrow,” he notes.

Phelps’s John Hancock Patriot Preferred Dividend Fund, with $155 million in assets, is currently yielding 6.33 percent, with 90 percent of its preferred investments DRD-eligible. The fund has taken a hit this year, declining 3.56 percent through July because of rising interest rates and a widening discount to net asset value, but its five-year annualized return is still an impressive 8.25 percent — 5.14 points ahead of the S&P 500. When long rates stabilize, the discount should narrow as investor concerns about climbing rates diminish.

One of the fund’s biggest positions is a credit play, reflecting the fact that preferred stock managers can mine value just like debt and equity investors do. Southern Union Co.’s double-B-plus-rated 7.55 percent preferred traded in mid-August at $25.90 and yielded 7.29 percent, for a tax-equivalent yield of 10.04 percent. Phelps says, “We established our 3 percent position between November 2003 and November 2005 as we saw this sleepy gas-distribution utility start to transform itself into a major regional pipeline player.”

Phelps’s average price is $26, just 10 cents above the preferred’s mid-August level. Boding well for his investment, the company’s common stock hit a 52-week high in late June.

With DRD yields approaching historic equity returns but carrying far less risk, says consultant Campbell, “these preferreds are among the most attractive investments ar