“Like stocks, preferreds are traded daily on an exchange. Like bonds, they pay fixed income on a regular basis (usually quarterly) and do not benefit from earnings growth of the issuing company,” explains Morningstar analyst Abby Woodham in a report on PFF. “In the capital structure, preferred stock is senior to common stock but junior to corporate bonds, and preferred shareholders have no voting rights.”
One important risk investors need to consider is the concentration in the financial sector. For example, PFF has about 86% of its portfolio in diversified financials, banks, real estate and insurance. Of course, the recent strong performance of the financial sector has provided a lift. [Preferred Stock ETFs for Yield]
From a country allocation, the preferred ETF has 77% in the U.S. and 23% in the United Kingdom, according to Morningstar.
Parnell notes that preferred stocks are trading at a premium to par, so they’re not a bargain at current prices.
“Also, the preferred stock market is subject to considerable price volatility at times,” he says. “Over the last four years in the aftermath of the financial crisis, the preferred stock market as measured by the PFF has experienced on three separate occasions sharp declines ranging from -10% to -15% over a matter of a few weeks if not days. In other words, an investor could see nearly three years worth of expected income associated with owning preferred shares completely offset by a decline in principal value that takes place in only a few days.”
The bottom line is that investors shouldn’t be lulled to sleep by the relatively low volatility and high dividends of preferred ETFs the past couple years.
“Like an unexploded ordinance, preferred stock allocations can exist for years with little notice in providing steady income and relatively low price volatility. But also like an unexploded ordinance, they also have the potential to explode into a violent episode of principal destruction in a matter of days,” Parnell concludes. “And while such an outcome is likely remote at present, the recent events in Cyprus serve as a reminder that we are but only one policy mistake away from the next major bout of extreme investment market volatility.”
iShares S&P U.S. Preferred Stock Index Fund
