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Time for Preferred Stock ETFs?

Zacks Equity Research

The recent surge in popularity of high yielding investment avenues is not at all surprising, considering the desire for income in this low rate environment. Fortunately, there are a number of options available to investors from the ETF space to focus on income.

While many investors have zeroed in on REITs, MLPs, and BDCs, these have arguably become bid up as more search for high income to fill the void in their portfolios. However, there is another option that many may not have considered but could still be an option for income, preferred stock.

What is Preferred Stock?

Preferred stock is a hybrid security that has the characteristics of both debt and equity. Preferred stock does not have voting rights but has a higher claim on the assets than common stock (Complete Guide to Preferred Stock ETF Investing).

That means that the dividends to preferred stock holders must be paid before any dividends are paid to the common stock holders. And in the event of bankruptcy, the preferred stock holders’ claims are senior to common stockholders’ claims, but junior to the claims of the bondholders.

The preferred stocks pay the stockholders a fixed, agreed-upon dividend at regular intervals, like bonds. Most preferred dividends have the same tax advantage that the common stock dividends currently have.

However, while the companies have the obligation to pay interest on the bonds that they issue, the dividends on preferred stock can be suspended or deferred by the vote of the board.

Preferred stocks have generally a low correlation with other income generating segments of the market like REITs, MLPs, corporate bonds and TIPs (Inside First Trust's New Preferred Securities ETF (FPE)).

Risk in Preferred Stock Investing

Although the yield provided by preferred stocks is impressive, these are also subject to certain risks. Preferred stocks carry the risk of regulation changes, higher interest rates and heavy concentration in financials.

The price of preferred stocks on the secondary market in general varies with interest rates, like bond prices. Investors should thus keep in mind that a rise in interest rates will lead to a fall in the value of these securities.

However, unlike bond prices, these are also sensitive to downward changes in interest rates. If interest rates fall the issuers have the option to call shares and reissue them at lower rates (Are Preferred Stock ETFs Worth the Risk?).

How to Invest… Preferred Stock ETFs

One of the most popular preferred stock funds is the iShares S&P U.S. Preferred Stock ETF (PFF). The fund manages an asset base of over $12 billion. This large asset base is invested in a holding of 322 securities.

These securities are mainly from the diversified financials, banks, and real estate sectors. In fact, diversified financials and banks take way almost 62% of the fund while another 11.35% is allocated to the real estate sector.

The current 30-day SEC yield on PFF is 5.51% and the fund charges a fee of 48 basis points annually (Two Unconventional Sources of ETF Yield).

Looking at the above, it is quite clear that the price of the fund has been steadily appreciating in the last one year period. In fact, currently the fund is trading near its all time high. The fund has delivered a return of 6.9% over a period of one year while its year-to-date returns stand at 3.1%.

In this low rate environment, investing in preferred stock ETFs has become very popular as they offer a steady source of income and a yield near the 6% level obviously makes the ETFs all the more attractive.

Other ways to tap the segment in basket form include:

SPDR Wells Fargo Preferred Stock (PSK)

Launched in Sep 2009, PSK tracks the pre expenses price and yield performance of Wells Fargo Hybrid and Preferred Securities Aggregate Index.

The ETF holds 138 securities in which it invests an asset base of $393 million. The ETF does well in eliminating concentration risk as it holds a mere 20.51% of its total assets in its top 10 holdings.

The fund charges only 45 basis points in fees and expenses, one of the lowest in this category. The ETF pays out a solid yield of 6.30%, making it ideal for investors seeking high levels of current income (What Does Your Income ETF Focus On?).

In the past one year, the fund has returned 3.7% and has delivered a return of 3.2% year to date.

PowerShares Financial Preferred ETF (PGF)

This product tracks the Wells Fargo Hybrid & Preferred Securities Financial Index which is a capitalization weighted index tracking the performance of preferred securities issued by financial institutions in the U.S. markets.

The fund holds 59 securities presently and allocates 45.65% of its assets in the top 10 holdings. Like most of its counterparts, PGF pays out an impressive yield of 6.17%.

It has returned a decent 5.7% in the last one year charging investors 66 basis points in fees and expenses. The expense ratio of this ETF happens to be one of the highest in the preferred stock ETF space.

Bottom Line

In this low rate environment, preferred stock ETFs offers an interesting source of yield for income hungry investors. Plus, they generally have lower levels of volatility than common stocks, and are not as bid up as other high yielders that are popular picks

However, they can be sensitive to interest rate changes, so monitor bond markets closely. If the interest rates rise going forward it will lead to a fall in prices of preferred stocks thereby leading to lower returns for investors.

But until that happens, preferred stock ETFs could be interesting picks in today’s economy that provide outsized income payments to investors, that is uncorrelated to broad markets as well.

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