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Preferreds Power Up Again

ETF Professor

With the Federal Reserve appearing unlikely to raise interest rates this year and some bond market participants speculating a rate cut later this year is possible, income-seeking investors are again embracing high-yield assets, including preferred stocks.

What Happened

Exchange traded funds, including the SPDR Wells Fargo Preferred Stock ETF (NYSE: PSK), have made preferred stocks more accessible to a broader swath of investors. PSK, which targets the Wells Fargo Hybrid and Preferred Securities Aggregate Index, is home to nearly $690 million in assets and is up about 8 percent year to date.

Preferreds are commonly viewed as hybrid securities that have qualities of both bonds and stocks, though the asset class probably less have an equity feel than some fixed income segments, such as convertible bonds.

Like common stocks, preferreds can gain value and like bonds, preferreds have fixed or floating interest payments, similar to a coupon on a regular bond.

Why It's Important

“The designation 'preferred' refers to their treatment relative to common shareholders: Preferred investors have priority claims to dividend payments and company assets in the event of liquidation,” said State Street in a recent note. “Preferred investors, however, are subordinate to bondholders and other creditors.”

Like corporate bond ETFs, preferred ETFs are often heavily allocated to the financial services sector, a trait that's the byproduct of the financial crisis and the yeas immediately following when banks issued preferreds and corporate debt to raise cash. About two-thirds of the preferreds held by PSK are issued by financial services companies.

PSK has a 30-day SEC yield of 5.13 percent, which is impressive for a portfolio of mostly investment-grade securities.

“Preferreds compare favorably to high-dividend stocks, investment-grade corporate bonds and the broader bond market,” said State Street. “While they yield less than high yield bonds, it’s worth pointing out that the index representing preferreds (PSK's index) is nearly all investment grade rated.”

What's Next

In addition to high yields, preferreds are embraced as a portfolio diversifier because the group has low correlations to other asset classes. PSK's underlying index has a 15-year correlation of 0.49 to junk bonds, the highest correlation the preferred benchmark has when measured against eight asset classes, including four bond segments.

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