The financial sector has been on a tear, jumping ahead of other market sectors so far in 2012, as investors feel more confident about riskier stock picks. For those still conscientious about income generation but feel like financials are making a comeback, preferred stock exchange traded funds could be a good fit.

Preferred stocks are a kind of hybrid of bonds and stocks. Investors who hold preferred stocks have a senior claim on earnings and assets in case of liquidation, compared to those who own common stocks. Additionally, preferred stocks generate dividends that are paid out before dividends for common stockholders. Preferred shares are generally safer than common stocks and offer higher yields.  Financial institutions are the predominate issuers of the share class, accounting for over 80% of all preferred shares, but others like energy, utilities and telecom companies also issue some preferred stocks.

However, preferred stock investors give up their voting rights, the investments tend to have a lower potential for capital appreciation and investors should watch out for interest rate risks down the line. For now, the Eurozone and the looming specter of a possible wide scale sovereign debt crisis remains a strong negative factor weighing on financials and preferred stocks.

Immediately following the financial crisis, most financial institutions issued preferred shares as a quick and cost-effective step to increase their Tier 1 capital – the basic measure of how regulators judge a bank’s financial adequacy, based on equity capital and disclosed reserves. Looking ahead, the new Dodd-Frank legislation and the additional Basel III rules will require banks to increase their Tier 1 capital and remove the eligibility of trust preferred stocks to qualify as tier 1 capital in 2013. Consequently, this will likely cause mass bank redemptions on preferred stocks.

Since the market expects large redemptions in a few years, prices will likely hold for now. Additionally, with a limited prospect of capital appreciation and a low interest rate environment, yields may maintain their high levels until the new regulation takes effect.

In the meantime, these investments could be suited for income investors looking for extra yield and willing to take on the risk in moving down the capital structure from debt.

Preferred Stock ETF Options

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