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
The iShares S&P U.S. Preferred Stock Index Fund (NYSEArca PFF) is the largest preferred stock ETF available, with 245 component holdings and a 0.48% expense ratio. Two sub-sectors make up the majority of the fund’s allocations, including diversified financials at 46.6% and banks at 25.4%. PFF has a 12-month yield of 6.99%.
The Powershares Financial Preferred Portfolio Fund (NYSEArca: PGF) tries to reflect the performance of the Wells Fargo Hybrid and Preferred Securities Financial Index, which follows holds U.S.-listed preferred securities issued by financial institutions. The fund has 45 holdings and a 0.66% expense ratio. PGF has a distribution yield of 6.91%.
PowerShares Preferred Portfolio Fund (NYSEArca: PGX) tries to reflect the performance of the BofA Merrill Lynch Core Fixed Rate Preferred Securities Index, which tracks a diversified group of investment-grade preferred securities. The fund has 92 holdings and an expense ratio of 0.50%. While the financials sector makes up a majority of the fund’s weighting, PGX also holds minor allocations toward utilities, telecom services, consumer discretionary and materials sectors. PGX has a distribution yield of 6.77%.
SPDR Wells Fargo Preferred Stock ETF (NYSEArca: PSK) tries to reflect the performance of the Wells Fargo Hybrid and Preferred Securities Aggregate Index, which is a market-cap weighted index comprised of non-convertible preferred stocks and securities, including depositary preferred securities, perpetual subordinated debt and other securities issued by banks or other financial institutes. The fund has 155 holdings and an expense ratio of 0.45%. Top sub-sectors include commercial banks, insurance, diversified financial services and real estate investment trusts. PSK has a 30-day SEC yield of 6.58%.
The iShares S&P Intl Preferred Stock Index ETF (NYSEArca: IPFF) tries to reflect the performance of the S&P International Preferred Stock Index, which tracks preferred stocks from non-U.S. developed market issuers. The fund has 66 holdings and an expense ratio of 0.55%. The financials sector is weighted at 78.5% of the ETF and energy is weighted at 11.8%. Country allocations include Canada 78.1%, U.K. 12.0%, Sweden 4.9%, Guernsey 1.7%, Singapore 1.6% and the U.S. 1.1%. IPFF has a 30-day SEC yield of 2.04%.
While exposure to foreign investments comes with greater potential risk and volatility, preferred shares issued by Canadian banks have been doing better than the U.S – IPFF has a large weighting in Canadian securities. Additionally, investors may take a more focused exposure to Canada’s preferred shares through the Global X ETF.
The Global X Canada Preferred ETF (NYSEArca: CNPF) tries to reflect the performance of the Solactive Canada Preferred Stock Index, which is based on a select group of preferred stocks from Canadian issues that trade on the Toronto Stock Exchange. The fund has 48 holdings and an expense ratio of 0.48%. The ETF is largely comprised of financial sector assets but also includes smaller allocations toward energy, telecommunications, utilities, consumer staples and consumer discretionary securities. CNPF has a distribution yield of 5.57%.