Finding asset classes and sectors that have been stung by tapering chatter and the subsequent rise in 10-year Treasury yields is not difficult. Unfortunately, some of the asset classes that are most vulnerable to rising rates are also prized by income investors. That list includes utilities stocks, master limited partnerships, real estate investment trusts and preferred stocks.
Preferred stock ETFs were among the prime beneficiaries of the Federal Reserve’s near-zero interest rate policy. In search of yield and an asset class with bond-like qualities, investors in droves poured cash into preferred ETFs. The iShares U.S. Preferred Stock ETF (NYSEArca: PFF) now has $9.9 billion in assets under management. The PowerShares Financial Preferred Portfolio (NYSEArca: PGF) has over $1.5 billion in assets. It has taken the Market Vectors Preferred Securities ex Financials ETF (NYSEArca: PFXF) just 13 months to eclipse $146 million in assets. [Preferred Stock ETFs: An Alternative Yield Source]
Investors enjoyed solid returns and yields often in excess of 5% with those ETFs and others. That is until speculation the Federal Reserve would move taper its $85 billion-per-month bond-buying program started creeping into financial markets in May. The market value of preferred stocks are affected by changes in interest rates. When rates rise, prices on the investments go down, but the effect is less noticeable on preferred stocks than fixed-income assets. [Rising Rates Weigh on Preferred Stock ETFs]
Over the past 90 days, PFF is off 9.5% while PGF has tumbled 10.2%. PFXF excludes bank stocks, a group most preferred ETFs are heavily allocated to, but the fund’s almost 30% weight to REITs is proving problematic. REITs have also been stung by rising rates, sending PFXF down 11% over the past three months. [Rising Interest Rates Burn Mortgage REIT ETFs]
Preferred ETFs may have another problem: A wide divergence from common stocks as measured by the S&P 500. The divergence is surprising because the two asset classes are more intimately correlated than some investors may believe.
As of August 15, the relative return gap for stocks over preferreds was 17%, “all of which has taken place over the last three months since early May. It should be noted that the last time that common stocks were experiencing a comparable performance gap over preferred stocks was back in late 2007 when the stock market was reaching new highs while the preferred stock market was in steady retreat.” according to Eric Parnell of Gerring Wealth Management.