What is an ETF? — Part 21: Preferred Stocks

August 3rd at 7:00am by Tom Lydon

Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 20: Long/Short Strategies]

Considering the lackluster yields on many fixed-income assets, investors have increasingly turned to alternative asset classes, such as preferred stock ETFs, to augment their income streams.

Preferred stocks are a type of hybrid security that exhibit the characteristics of equity and bond instruments. The shares are issued by financial institutions, utilities and telecom companies.

The Trust Preferred Shares, or TruPS, make up the lions share of the preferred share market and are considered Tier 1 capital, which let banks meet their capital requirements.

Although, it should be noted that on Jan. 1, 2013, banks will not be able to use preferred shares as Tier 1 capital unless they are issued as non-cumulative perpetual preferred stock, a form of preferred stock that the issuer has waived payment of dividend payments. As such, banks could stop issuing new share and may even call in outstanding shares that no longer help the bank meet capital requirements. Additionally, in 2013, TruPS will continue to count as Tier 1 capital but at a 67% rate.

For the investor, preferred stocks fall somewhere between bonds and stocks. Preferred share dividends take precedent over common share dividends but fall below bonds in a company’s debt obligation hierarchy.

As many investors have noticed, this class of stocks provides high yields, but unlike regular stocks, the dividends are fixed, so investors can rely on a relatively stable source of income.

Additionally, potential investors should note that traditional preferred securities, or DRDs, and qualified dividend income, or QDI, preferreds fall under the favorable tax rates.

However, investors need to be aware of the potential downsides. For instance, preferred stocks do not offer a high degree of capital appreciation – the investor can only rely on the dividend payouts.

Company issuers may call in the shares – if interest rates drop, the issuer may buy back shares to issue new ones at lower rates, but if rates increase, the outstanding preferred shares may offer less yields than the prevailing market rates.

Moreover, preferred stocks are heavily weighted in financial services, telecommunications and utility companies.

  • Global X SuperIncome Preferred ETF (NYSEArca: SPFF): started trading on July 16, 2012.
  • Global X Canada Preferred ETF (NYSEArca: CNPF): 3.4% 30-day SEC yield.
  • iShares S&P International Preferred Stock Index Fund (NYSEArca: IPFF): 3.25% 30-day SEC yield.
  • iShares S&P US Preferred Stock index Fund (NYSEArca: PFF): 6.25% 30-day SEC yield.
  • Market Vectors Preferred Securities ex-Financials ETF (NYSEArca: PFXF): started trading on July 16, 2012.
  • PowerShares Preferred Portfolio (NYSEArca: PGX): 6.62% 30-day SEC yield.
  • PowerShares Financial Preferred Portfolio (NYSEArca: PGF): 6.74% 30-day SEC yield.
  • SPDR Wells Fargo Preferred Stock (NYSEArca: PSK): 6.67% yield.

For past stories in this series, visit our “What is an ETF?” category.

Max Chen contributed to this article.

Story updated to correct information on preferred stocks.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.