PowerShares Launches Variable Rate Preferred ETF

Zacks Equity Research

PowerShares appears to be leaving no stone unturned in the preferred stock ETF space. After carrying on its activity in the fixed rate preferred stock ETF space for so long, the issuer recently came up with a ground-breaking product in the pursuit of trying out floating rate preferred stock ETFs. The new fund – Variable Rate Preferred Portfolio which looks to trade under the symbol of VRP –hit the market on May 1, 2014.

The Fed’s effort to phase out the monetary stimulus has spurred rising rate fears this year leading to the urgency to launch a unique product to counter the rise. Notably, floating rate bonds and preferred stocks are both individually good products to bet on in a rising rate environment.

Thus, combining the two traits in a single product seems like a nice idea from PowerShares. Being the first product in the space, VRP should also enjoy some first-mover advantage in this corner of the market as well (read: Protect Against Rising Rates with Floating Rate ETFs).

VRP in Focus

The ETF looks to track the Wells Fargo Hybrid and Preferred Securities Floating and Variable Rate Index. This benchmark intends to reflect the performance of preferred stocks, as well as some types of "hybrid securities" that are quite similar to preferred stocks in nature that are issued by U.S.-based or foreign issuers and pay a floating or variable rate coupon.

Per the issuer, “variable-rate preferred securities are normally issued at rates below fixed-rate preferred securities of similar quality in exchange for the issuer, bearing most of the risk for changes in interest rates”.

The product seeks to have a tracking error of less than 5%. This exposure isn’t too pricey either, as the fund looks to charge investors 50 basis points a year in fees. This is true when compared to other fixed-rate preferred stock options out in the market that charge more or in line with the newly launched product (read: Time for Preferred Stock ETFs?).

How might it fit in a portfolio?

At a time like this when investors are growing increasingly concerned about rising rate risks and stock market turbulence, the Fed has trimmed asset purchases four times since December last year. In fact, the Fed is expected to wrap up tapering by this October.

Meanwhile, the Fed hinted at hiking the short-term rate mid next year, but pared down its comments a few days after it was made. Stock markets have been flat this year thanks to not-very-encouraging economic indicators. The U.S. economy hardly grew in Q1, representing the slowest growth in more than one year.

In such a situation, investors are desperately looking for high income and low interest rate responsive products. And to accomplish this investing goal, VRP comes across as one of the best-suited products.

The preferred stocks are a hybrid of both bonds and stocks. These offer considerably higher yields, along with the opportunity for capital appreciation. These also pay coupons in a periodic manner. These products are normally less correlated with other income generating vehicles available in the market such as MLPs and REITs (Are Preferred Stock ETFs Worth the Risk?).

These were the normal characteristics of preferred stocks. The benefits are more impressive in variable preferred stocks than the fixed rate ones. The value of the dividend from the variable preferred share is linked to movement in benchmark interest rate. Some of the popular benchmarks include LIBOR and Treasury rates.

And because of this elasticity, variable preferred prices are steadier than fixed-rate preferred stocks.  The product is also attractive to the investors who are in top-tax bracket as dividends from variable-rate preferred securities also obtain preferential tax rates compared to interest income.

Competition

This preferred stock strategy appears beneficial for investors given the ongoing rising rate concerns and ongoing volatility that are troubling securities and could put pressure on the traditional high yielding products as well. The new product could deliver a higher yield than the dividend-focused counterparts and reduce the volatility of returns during various market cycles aided by its innovative strategy.

Not only this edge, the product will see an empty arena to fight for AUM as it will be the first-ever variable rate preferred ETF. PowerShares already has two preferred stock ETFs in its lineup – PowerShares Preferred Portfolio (PGX) and PowerShares Financial Preferred Portfolio (PGF) – but these are fixed rate preferred stock ETFs (read: AdvisorShares Debuts YieldPro ETF).

There are several other fixed-rate preferred stock ETFs as well with iShares U.S. Preferred Stock ETF (PFF) dominating the space. All these funds have gained in the range of 5% to 7% so far this year.  So, VRP with its dual swords to battle rising rates – variable rate and preferred stocks – should not face any hurdle in amassing investors’ money.

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