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Preferred ETFs Yielding Over 6% But Come with Risks

tlydon@globaltrend.com (Tom Lydon)

Preferred stock ETFs are offering yields of more than 6% but their recent price volatility illustrates their risk and dependence on the financial sector after JP Morgan (JPM - News) disclosed unexpected trading losses.

Some of the largest ETFs in the category include SPDR Wells Fargo Preferred Stock (PSK - News), PowerShares Preferred ETF (PGX - News), PowerShares Financial Preferred ETF (PGF - News) and iShares S&P U.S. Preferred Stock ETF (PFF - News).

“Preferreds are hybrid securities that have characteristics of both stocks and bonds, and are typically issued by financial institutions, utilities, and telecom firms,” explains Morningstar’s Timothy Strauts in an analyst report on PFF. “It makes regular income payments and is rated by the major credit-rating agencies. Preferreds have no voting rights, are senior in the capital structure to common stock, and have priority over common stock in the payment of dividends.”

Preferred stock ETFs have heavy allocations in financial institutions. For example, PSK has 83.8% in the financial sector, according to manager State Street Global Advisors. [Investors Chase Yield with Preferred Stock ETFs]

“While preferred funds are certainly providing a healthy, relatively high yield in a low yield environment, the extra yield comes with a lot of volatility,” writes Russ Koesterich at the iShares blog. “Currently, preferred funds are offering a yield similar to that of a high-yield bond fund, but preferred funds are also offering about 50% more volatility.”

Financial ETFs such as Financial Select Sector SPDR (XLF - News) got off to a fast start in 2012 but have fallen harder than the overall market during the May pullback. Investors are worried about Greece potentially exiting the euro and the possibility of more nasty surprises on bank balance sheets after the JP Morgan bombshell. [Financial ETFs and JP Morgan's London Whale]

“To be sure, preferred stocks are generally more volatile than bonds and this makes sense given their lower place in the capital structure,” Koesterich said.

However, the heavy concentration in financials is also driving price swings because the financial sector is now the most volatile sector in the market.

“As such, preferred funds modeled on the index are essentially acting as proxies for financial stock funds, but with equity-like risk and bond-like returns,” he wrote.

iShares S&P U.S. Preferred Stock ETF