In a report on PFF, Morningstar analyst Abby Woodham explains preferred stock is a hybrid security usually issued by highly leveraged companies, such as financial institutions, telecoms, and utilities.
“Preferred stock has characteristics of both bonds and stocks. 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,” she wrote. “In the capital structure, preferred stock is senior to common stock but junior to corporate bonds, and preferred shareholders have no voting rights.”
Investors should also realize that preferred stock ETFs are typically concentrated in the financial sector. For example, PFF has about 84% of its portfolio in diversified financials, banks, real estate and insurance.
There are other important risks.
“Preferreds are sensitive to interest rates, but unlike bonds, they are at risk in both directions. When rates fall (an unlikely event in coming years), issuers are incentivized to call shares and reissue at lower rates that are more favorable to them. When rates go up, preferred stock prices fall,” says Morningstar’s Woodham.
Dieterich also points to call risk. “Perpetuals can be called at any time; other maturities are usually callable after five years. Banks—among the biggest issuers of preferred stock—are now calling them in droves and issuing new preferreds with lower rates,” he wrote.
Other ETFs in the category include PowerShares Preferred Portfolio (NYSEArca: PGX), SPDR Wells Fargo Preferred Stock ETF (NYSEArca: PSK), Market Vectors Preferred Securities ex Financials ETF (NYSEArca: PFXF), First Trust Preferred Securities and Income Fund (NYSEArca: FPE) and Global X SuperIncome Preferred ETF (NYSEArca: SPFF).
Full disclosure: Tom Lydon’s clients own JNK and HYG.