Amid historically low interest rates and no threat that the Federal Reserve would deviate from that course, exchange traded funds holding preferred stocks became favored destinations for yield-hunting income investors.
With the interest rate outlook appearing far less sanguine as the Fed readies to boost borrowing costs, perhaps as soon as June, advisors and investors should take the opportunity to assess the place preferred ETFs in portfolios.
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. [Rate Risk With Preferred ETFs]
High yields coupled with preferred shareholders having a better seat at the table in the even of issuer default than do common shareholders have been among the sources of allure for ETFs such as the iShares U.S. Preferred Stock ETF (NYSEArca: PFF) and PowerShares Preferred Portfolio (NYSEArca: PGX).
The $13 billion PFF has a 30-day SEC yield of 5.48% while the $2.82 billion PGX has a 30-day SEC yield of 5.91%. It is yields like that require advisors and investors to answer important question as Treasury yields ebb higher: Are preferred stocks behaving more like bonds or common equities? [Preferred ETFs Loving Falling Rates]
“Over a three year period, the annualized returns of the U.S. preferred market have been more bond like than equity like. The S&P U.S. Preferred Stock Index had a three year annualized return of 7.95% while long U.S. Treasury bonds have returned 8.14%. Meanwhile, the three year annualized return of the S&P 500 has been well over 15%,” notes J.R. Rieger, global head of fixed income at S&P Dow Jones Indices.
Investors seem to be buying into the notion that preferred ETFs behave more like stocks than bonds. As much is highlighted by the combined 2015 inflows of roughly $1.6 billion into PFF and PGX.
“While it is easy to relate the performance of preferred stock and long term bonds to interest rate changes, the two asset classes have shown a low correlation to each other over the last three years. Actually, the S&P U.S. Preferred Stock Index has had a higher correlation to the S&P 500 than it did to long term to bonds. There is a danger in just looking at the last three years of course as interest rates have been held low during the period,” adds Rieger.
There are ways for investors to stick with preferred even if rates do rise. For example, the PowerShares Variable Rate Preferred Portfolio Fund (NYSEArca: VRP) could prove attractive to income investors when interest rates rise because most preferred shares are either perpetual or sport long durations, making the issues sensitive to higher rates.
Variable-rate preferreds usually carry lower interest rates than fixed-rate preferreds of comparable credit quality. However, the trade-off there is an ETF such as VRP should be less sensitive to interest rate changes
VRP is just 11 months old and already has $160.6 million in assets, indicating there is an audience for an ETF that helps maintain preferred equity exposure without the interest rate risk found in traditional preferred ETFs. [Fast Start for a new Preferred ETF]
VRP has an effective duration of four years and a 30-day SEC yield of 4.84%. Investors have added almost $42.4 million in new assets to the ETF this year.
PowerShares Variable Rate Preferred Portfolio