Preferred Stock ETFs: Are 6% Yields Worth the Risk?

ETF Trends

The iShares S&P U.S. Preferred Stock Index Fund (PFF) is up 3% so far this year and just capped its sixth straight quarter of gains to trade at its highest price level since the financial crisis.

For conservative investors who want to avoid volatility and generate yield, preferred stock ETFs have fit the bill nicely. PFF, the category’s largest ETF with $11.9 billion in assets, pays a 12-month yield of 6%.

Slow and steady wins the race, especially for investors shell-shocked by the dot-com meltdown and 2008 global credit storm. [Preferred ETF Trying to Break Out]

And with the Federal Reserve holding short-term interest rates near zero, investors who rely on income have been forced to take on more risk in search of yield. They have gravitated to ETFs tracking high-yield corporate bonds, dividend stocks and preferred shares, for example.

For over three years, investors in preferred stock ETFs have been able to relax and let those dividend payments roll in like clockwork, with very little price volatility to boot.

But are they being lulled into a false sense of security? Eric Parnell, founder of Gerring Wealth Management, thinks so.

“Preferred stocks are one such category where income thirsty investors have been flocking as of late. Unfortunately, these same investors are now sitting on what is effectively an unexploded bomb and they may not even know it,” he writes in a Seeking Alpha post.

‘Unexploded ordinance’

Preferred shares are hybrid securities that combine features of both stocks and bonds.

“Like stocks, preferreds are traded daily on an exchange. Like bonds, they pay fixed income on a regular basis (usually quarterly) and do not benefit from earnings growth of the issuing company,” explains Morningstar analyst Abby Woodham in a report on PFF. “In the capital structure, preferred stock is senior to common stock but junior to corporate bonds, and preferred shareholders have no voting rights.”

One important risk investors need to consider is the concentration in the financial sector. For example, PFF has about 86% of its portfolio in diversified financials, banks, real estate and insurance. Of course, the recent strong performance of the financial sector has provided a lift. [Preferred Stock ETFs for Yield]

From a country allocation, the preferred ETF has 77% in the U.S. and 23% in the United Kingdom, according to Morningstar.

Parnell notes that preferred stocks are trading at a premium to par, so they’re not a bargain at current prices.

“Also, the preferred stock market is subject to considerable price volatility at times,” he says. “Over the last four years in the aftermath of the financial crisis, the preferred stock market as measured by the PFF has experienced on three separate occasions sharp declines ranging from -10% to -15% over a matter of a few weeks if not days. In other words, an investor could see nearly three years worth of expected income associated with owning preferred shares completely offset by a decline in principal value that takes place in only a few days.”

The bottom line is that investors shouldn’t be lulled to sleep by the relatively low volatility and high dividends of preferred ETFs the past couple years.

“Like an unexploded ordinance, preferred stock allocations can exist for years with little notice in providing steady income and relatively low price volatility. But also like an unexploded ordinance, they also have the potential to explode into a violent episode of principal destruction in a matter of days,” Parnell concludes. “And while such an outcome is likely remote at present, the recent events in Cyprus serve as a reminder that we are but only one policy mistake away from the next major bout of extreme investment market volatility.”

iShares S&P U.S. Preferred Stock Index Fund

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The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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