Preferred securities can be split into two basic categories: traditional preferred stock, eligible as qualified dividend income (QDI) for individuals and generally eligible for the inter-corporate dividends received deduction (DRD) for corporations, and hybrid or taxable preferred securities. Traditional preferreds represent an equity position in the issuing company, while hybrid preferreds are a subordinated debt obligation of the company. Both securities rank senior to common stock shares. Information on individual preferred securities can be found on the Flaherty & Crumrine sponsored website www.preferredstockguide.com.

Preferred securities may pay dividends or interest, as applicable, at a fixed rate, or at a variable rate determined either by formula or through a Dutch auction process. Preferred securities normally have only contingent voting rights and do not directly participate in the growth or profitability of the company.

Most preferred securities are cumulative, in which case all dividends or interest payments that have not been paid will accumulate and must be paid before holders of common stock receive any dividends. In certain instances, failure to pay preferred dividends entitles preferred shareholders to representation on the company's Board of Directors. In the event of liquidation, preferred shareholders must be paid all dividends and principal before distributions may be made to common shareholders. The majority of preferred securities are listed on the major stock exchanges, and specialized trading departments of several investment brokerage firms further enhance liquidity.

Some preferred securities are convertible into the common stock of the issuing corporation, but the vast majority is not. Returns from investment grade preferred securities correlate much more closely with investment grade bonds and US Treasury securities than with common stocks or "junk" bonds. Preferred portfolios managed by Flaherty and Crumrine have typically averaged low "A" to high "Baa" by the rating services, although we often have authority to purchase a small percentage of the portfolio in below investment grade rated preferreds.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 lowered the maximum rate paid by individuals on certain types of QDI to 15%. Prior to this legislation, dividend income was typically taxed at the same rate as ordinary income. The majority of the issues distributing QDI are also eligible for the DRD. (Please refer to www.preferredstockguide.com for individual classifications).

Preferred stock eligible for the DRD entitles certain corporate investors to exclude 70% of the dividend received from their taxable income. The issuer, however, may not deduct these dividend payments when computing its taxable income. Such issues include adjustable rate preferred stock (ARPS), auction or re-marketed preferred stock, and fixed rate preferred stock (either with or without mandatory sinking fund provisions). Issues eligible for the DRD total approximately $63 billion as of 9/30/06.

Hybrid preferred securities pay dividends that are fully taxable as ordinary income to the investor, but the issuing company may deduct the payments as interest expense. Depending on the terms of each issue, taxable preferred securities rank equal or senior to DRD preferred stock of the same issuer. Most hybrid issues allow the issuer to defer interest payments, typically up to 20 consecutive quarters, without triggering an act of default. These issues are usually callable or exchangeable into debentures of the parent company under certain circumstances. Taxable preferreds may be issued directly by a corporation or by a trust established by the corporation and fully guaranteed by such corporation. The taxable preferred securities market is approximately $244 billion as of 9/31/06 and has grown rapidly since its origin in late 1993.