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Risks Intensify For Preferred Stock ETFs, As Interest Rates Rise

Tuesday, March 14, 2017 4:17
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From David Fabian: Preferred stocks offer the distinction of being unique hybrid instruments with qualities of both stocks and bonds. In that manner, they offer healthy dividend yields alongside a favored position in the capital structure of many companies that issue these securities.

The reason company’s issue preferred shares are to raise capital from investors that are seeking an attractive yield without adding traditional debt (bonds) that carry strict maturity dates and covenants. Preferred stocks can also be “callable” from the issuer, who has the right to redeem them at a certain price or time at their discretion.

Sometimes the prices of preferred stock indexes follow the path of the stock market and other times they follow a closer inverse relationship to interest rates, like bonds. The result is an alternative income producing asset class with distinctive risk and reward dynamics that must be carefully considered before adding them to your portfolio.

The largest exchange-traded fund in this space is the iShares U.S. Preferred Stock ETF (PFF). This well-known index-based ETF invests in a basket of nearly 300 preferred stock issues of primarily publicly traded U.S. companies. Think companies like Wells Fargo & Co (WFC), HSBC Holdings PLC (HSBC), and GMAC Capital (ALLY).

The sector makeup of PFF is overwhelmingly dominated by banking, financial, insurance, and real estate stocks. Currently this ETF offers a 30-day SEC yield of 5.28% and charges an expense ratio of 0.47% annually as well.

Examining recent one-year chart below, it’s notable that PFF peaked near the bottom in interest rates in mid-2016 and has been slowly trying to reclaim that prior high. This fund has once again come under fire as signals of more frequent Federal Reserve rate hikes spook interest rates back to the top of their recent range.

The next big test for PFF is whether it will be able to hold its long-term 200-day moving average or if it gets sucked down once again by sharply rising Treasury yields. It appears that once again this index is taking its cues from bond holders in terms of its recent price action.

Some investors may be under the impression that PFF the only ETF in this category because of its dominating $17 billion in total assets that dwarfs the competition. However, there are several options for investors to consider in this category with varying portfolio fees and characteristics.

The PowerShares Preferred Portfolio (PGX) is the second largest ETF in this class with $4.5 billion in total assets. The underlying PGX portfolio and historical returns are markedly similar to PFF, which is why these funds are often interchangeable in terms of security selection.

One truly distinctive option to consider is the PowerShares Variable Rate Preferred ETF (VRP). This fund holds a basket of preferred stocks and floating rate securities with variable coupon payments. The intent is to offer a similar income dynamic to a traditional basket of preferred stocks with less interest rate risk than a fund like PFF. This ETF has become a popular landing spot for more investors over the last several years as concerns of rising rates have driven assets in VRP to over $1 billion.

As you can see in the comparison chart below, VRP has significantly outperformed its more conventional peer group over the last 52-weeks. No doubt much of this alpha has been driven by the moderated interest rate sensitivity.

Lastly, the Elkhorn S&P High Quality Preferred ETF (EPRF) was recently released to try and curry favor among income enthusiasts for its variant underlying index. This new fund offers a more concentrated portfolio of just over 100 securities from issuers with investment grade credit ratings. The intent is obviously to cull a basket of high quality fixed-rate preferred securities that eschews the credit risk of smaller or more financially risky companies.

The Bottom Line

Income investors have several attractive preferred stock ETFs at their disposal and new entrants are raising the bar even further. However, the real question is how these funds will react to additional upside in interest rates if that is indeed the prevailing trend throughout 2017. In my opinion, positioning these funds as smaller allocations and examining how they fit in the context of existing fixed-income exposure will be key to a successful outcome.

The iShares U.S. Preferred Stock ETF (NYSE:PFF) rose $0.15 (+0.4%) in premarket trading Tuesday. Year-to-date, PFF has gained 1.91%, versus a 6.39% rise in the benchmark S&P 500 index during the same period.

PFF currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 15 ETFs in the Convertible Bond/Preferred Stock ETFs category.

This article is brought to you courtesy of FMD Capital.

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