Preferred Stock ETFs Offer High Yields But Mind The Rate Risk

Exchange traded funds that track preferred stocks provide investors with an attractive source of yields. However, as witnessed last year, preferred shares are vulnerable to rising interest rate environments.

As benchmark 10-year Treasury yields stay below 3%, Investors have found preferred stocks as an attractive alternative source of income. For instance the iShares U.S. Preferred Stock ETF (PFF) , the largest offering in the space with $8.7 billion in assets under management, shows a 6.33% 12-month yield. PFF has a 0.48% expense ratio. [Indexology: The Power of Dividends: Preferred Stock]

The fund, though has gained 5.3% year-to-date as Treasury yields have declined.

Nevertheless, with the Fed tapering its bond purchasing program and looking to the jobs market and economy as indicators for the eventual hike in benchmark rates, preferred stocks could be vulnerable ahead.

Preferred stock ETFs began to decline in May 2013 on Fed tapering and on concerns of rising interest rates. PFF is down 6.6% since its May 2013 high as benchmark 10-year Treasury yields gained over 100 basis points from a 1.63% low.

“Much like bonds, preferred stock becomes less attractive in a rising rate environment, so PFF’s holdings must decline in price to bring their yield up to an attractive level,” according to Morningstar analyst Abby Woodham. “Most preferred stock is either perpetual or extremely long-dated, which exposes investors to significant interest-rate risk.”

Moreover, investors need to be aware that preferred stock ETFs have a heavy exposure to the financial sector. PFF allocates 37.2% to diversified financials, 28.2% to banks and 10.2% to insurance companies.

Alternatively, the PowerShares Preferred Portfolio (PGX) employs a credit screen, so component holdings have a higher credit quality than other preferred ETFs. The financial services sector also looms large in the fund, accounting for 87.9% of its holdings. PGX has a 0.5% expense ratio and shows a 6.41% 12-month yield, The ETF is up 5.2% year-to-date. [Preferred Stock ETFs Yielding 6% Still Chugging Along]

The SPDR Wells Fargo Preferred Stock ETF (PSK) takes an even more conservative approach, holding 75.2% in Baa low investment-grade securities and another 10% in A-rated securities. Financials also make up a heavy portion of the portfolio at 81.1%. PKS has a 7.26% 12-month yield and comes with a 0.45% expense ratio. The ETF is up 7% year-to-date.

Preferred stocks are a type of hybrid security that show bond- and equity-esque characteristics. The shares are issued by financial institutions, utilities and telecom companies, among others. Within the securities hierarchy, preferreds are senior to common stocks but junior to corporate bonds. Preferred stocks issue dividends on a regular basis, but investors are unlikely to enjoy capital appreciation on par with common shares.

For more information on preferred ETFs, visit our preferred stocks category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, 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.