Preferred stock ETFs have been on fire this year as income investors have hungrily sought high yield and capital appreciation opportunities.
These hybrid securities offer characteristics of both equity and debt instruments which coalesce to generate a healthy income stream with low correlation to traditional stock indices.
From a capital structure standpoint, preferred stocks are listed above common equity and issuers are mandated to pay dividends on preferred stocks before common shareholders.
The iShares U.S. Preferred Stock ETF (NYSE: PFF) is the largest fund in this arena with nearly $10 billion invested in 315 preferred securities.
This sector is typically dominated by preferred holdings in financial companies, real estate, and banks.
Currently, PFF pays a 30-day SEC yield of 5.77 percent and distributes income on a monthly basis to shareholders. This monthly dividend schedule is differs from traditional dividend-equity ETFs that distribute income quarterly and is an attractive quality for income seekers.
In addition, PFF has gained 10.13 percent on a total return basis so far this year and charges an expense ratio of 0.47 percent.
While most preferred stocks have a fixed dividend payout structure, there are some unique securities that offer a variable or floating rate component as well. The PowerShares Variable Rate Preferred Portfolio (NYSE: VRP) is a new ETF that seeks to capture these hybrid securities through a market cap weighted index.
The 83 underlying holdings in VRP are considered to be functionally equivalent to traditional preferred stocks with the addition of an coupon payment that can shift based on a spread to an established benchmark such as LIBOR.
This variable coupon component typically resets on a short-term schedule, similar to senior loans.
The VRP portfolio is made up almost entirely of preferred securities in the financial sector, with small additions of energy and utility stocks as well. Because this new ETF has yet to pay a dividend, it is still unclear what the initial yield will be and how it will react to changes in interest rates.
The flexibility to adjust to higher rates may ultimately be another tool for income investors to consider if we experience another wave of yield curve volatility in the future.
Disclosure: Author is long PFF at the time this article was published.
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