Through years of the Federal Reserve’s near-zero interest rate policy, exchange traded funds holding preferred stocks gobbled up assets from income investors. However, with rates to set rise as soon as next month, rate-sensitive preferreds and the relevant ETFs could come under pressure.
Income investors may like preferred stock ETFs since the asset class offer stable dividends, don’t come with taxes on qualified dividends for those that fall into the 15% tax bracket or lower, are senior to common stocks in the event liquidation occurs, are less volatile than bonds and provide dividend payments before common shareholders.
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. Additionally, preferred stocks issue dividends on a regular basis, but investors are unlikely to enjoy capital appreciation on par with common shares.
The iShares U.S. Preferred Stock ETF (NYSEArca: PFF) and the PowerShares Preferred Portfolio (NYSEArca: PGX), each with trailing 12-month dividend yields in the area of 6%, are among the marquee preferred ETFs.
“If interest rates remain low, and the economy remains stable, preferred stocks funds should prosper. Preferred ETFs have low volatilities so are excellent choices for the risk averse investor. Among the ETFs, four had the similar performance: PGX, PGF, PFF, and PSK. If you had to choose one, I would go with PGX or PGF,” according to a Seeking Alpha analysis of preferred ETFs.
Like bonds, preferreds are sold at par value, or offer a fixed or floating rate of income, so prices fluctuate with interest rates, writes William Scapell, director of fixed income and preferred securities portfolio manager at Cohen & Steers, for InvestmentNews.
While preferred stocks provide investors with an attractive source of yields, potential investors should keep in mind that the assets are vulnerable in a rising interest rate environment. If rates rise, the holdings must decline in price to elevate their yield to attractive levels. Furthermore, most preferred stocks are either perpetual or long-dated, which exposes investors to significant interest-rate risk. [Evaluating Preferred ETFs Ahead of a Rate Hike]
Another option to consider is the PowerShares Variable Rate Preferred Portfolio Fund (NYSEArca: VRP). Variable-rate preferreds usually trade mroe like bonds with shorter durations, so more conservative investors may find the lower-risk profile more appealing. However, VRP comes with a lower 4.57% 12-month yield. [The Right Preferred ETF Right Now]
iShares U.S. Preferred Stock ETF
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.