Income seekers who are cashing in on the high yields offered by preferred stock exchange traded funds should start to look over their positions as a rising interest rate environment will significantly impact these hybrid assets.
So far this year, the preferred stock ETFs have outperformed the broader market. The iShares U.S. Preferred Stock ETF (NYSEArca: PFF) and PowerShares Preferred Portfolio (NYSEArca: PGX) have increased 12.2% and 11.5%, respectively, whereas the S&P 500 is up 6.9%.
Additionally, the funds come with attractive yields, with the PFF showing a 12-month yield of 6.85% and PGX issuing a 6.11% yield. Both ETFs issue dividends monthly. Potential investors should be aware that tax treatment on preferred distributions can vary, with the majority of distributions taxed as qualified dividend income over the past few years.
Preferred stocks are a type of hybrid security that show bond- and equity-esque characteristics. The shares are issued by financial institutions, utilities and telecom companies, among others. Within the securities hierarchy, preferreds are senior to common stocks but junior to corporate bonds. Preferred stocks issue dividends on a regular basis, but investors are unlikely to enjoy capital appreciation on par with common shares. [Preferred ETFs Loving Lower Rates]
While preferred stocks provide investors with an attractive source of yields, the assets are vulnerable to rising interest rate environments.
“Much like bonds, preferred stock becomes less attractive in a rising-rate environment, so [preferred stock ETFs’]holdings must decline in price to bring their yield up to an attractive level,” according to Morningstar analyst Abby Woodham. “Most preferred stock is either perpetual or extremely long-dated, which exposes investors to significant interest-rate risk.”
For instance, when the benchmark yields on 10-year Treasuries spiked from 1.63% to almost 3.0% between May and September last year, PFF declined 7.3% and PGX decreased 8.7% over the same period.
Preferred stock ETFs are notably sensitive to rate changes due to their heavy allocation toward perpetual preferreds, which have no maturity date, or perferreds with extremely long maturity dates. Woodham points out that perpetual preferreds make up almost half of PFF’s holdings and over half of PGX’s components.
For more information on preferred stocks, visit our preferred stocks category.
Max Chen contributed to this article.