As the portfolio manager for the iShares preferred stock ETFs, I spend a lot of time with our sales team and investors, helping them to understand the complexity of these products.

With investors increasingly concerned about a potential rise in interest rates this year, the conversation I’ve been having a lot lately is about how a rate increase might affect preferred stocks, including the iShares S&P US Preferred Stock Index Fund (NYSEArca: PFF).

Before answering the interest rate question, let’s quickly revisit how preferred stocks work.

These are income generating, “hybrid” securities that possess traits found in both equity and debt instruments.

Senior to common stock and subordinate to fixed income in the capital structure, preferreds are usually characterized by higher yield potential and higher risk than bonds, with less opportunity for capital appreciation than common stocks.

Example of a Corporate Capital Structure

Like bonds, preferred stocks are issued at par value and pay “fixed or floating” income (in the form of dividends or interest) based on a percentage of par. Most of them are also assigned a rating by the major credit rating agencies, like Moody’s and S&P. As a result, their prices are sensitive to interest rate changes and credit risk of the issuer.

Many preferreds also have call options embedded in them, meaning the issuer has the right to call or redeem the shares, typically after a lock-up period of five years. Just like a call option in a bond, when the price of the preferred rises above the call price, the issuer may decide to call the security. But the issuer is under no obligation to do so. Instead, issuers tend to look at a range of options when deciding whether or not to redeem shares, including the cost of issuing debt and their overall capital structure.

Next page: Preferred shares and rising rates

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