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How Preferred Stock ETFs Handles Rising Rates

This article was originally published on ETFTrends.com.

As a high-yield asset class, preferred stocks can be vulnerable to rising rates, but there are ways for investors to stay involved with preferreds even as the Federal Reserve tightens its monetary policy.

Preferred stocks are a type of hybrid security that show bond- and equity-like 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. Additionally, preferred stocks issue dividends on a regular basis, but investors don’t usually enjoy capital appreciation on par with common shares.

The Global X U.S. Preferred ETF (Cboe: PFFD) features floating, variable and fixed-rate preferreds, which can help investors endure higher interest rates.

“Floating rate preferreds pay adjustable income levels, known as coupons, for the life of the preferred security. The formula for determining the coupon payment is usually benchmarked to 3-month ICE LIBOR (London Interbank Offering Rate) plus a fixed spread, which is based on the issuer’s credit risk,” said Global X in a research note. “As interest rates rise, this formula dictates that the coupon payments to investors increase. Conversely, if rates fall, the coupon is expected to decrease. Given this adjustable coupon payment based on prevailing interest rates, these preferreds tend to have lower durations than fixed-rate preferreds.”

More Perks for Preferred Stock ETFs

Income investors have looked to preferred stock ETFs in their portfolios for a number of reason. For instance, the asset class offers stable dividends, does not come with taxes on qualified dividends for those that fall into the 15% tax bracket or lower, is senior to common stocks in the event liquidation occurs, is less volatile than bonds and provides dividend payments before common shareholders.

Related: Fixed Income Expert Says Watch Front of Yield Curve

PFFD has a 30-day SEC yield of 5.48%. Over 53% of the fund's holdings are rated between BBB+ and BBB- while more than 38% carry ratings of between BB+ and BB-.

“Fixed-to-float and floating rate preferreds remain an important segment of the preferred market, so they should not necessarily be avoided, but investors should be cognizant of the features presented in these securities,” said Global X. “It may be more appropriate in this environment to think of this segment of the market as a complement, rather than a replacement, for the preferred part of a portfolio.”

PFFD charges just 0.23% per year, or $23 on a $10,000 investment, making it one of the least expensive preferred ETFs on the market.

For more fixed income investment solutions, visit the Fixed Income Channel.

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