Count preferred stocks and exchange traded funds among the income-generating asset classes that are receiving renewed attention from income investors this year as the Federal Reserve balks at raising interest rates.
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) sport tempting yields that average out to about 5.8%. Like many preferred ETFs, PFF and PGX are heavy on preferred issued by financial services companies.
[related_stories]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.
Like bonds, preferreds are sold at par value, or offer a fixed or floating rate of income, so prices fluctuate with interest rates.
“Although the performance of these funds in terms of yield and YTD returns is very similar, and there is little difference between the expense ratios, the PowerShares Preferred ETF holds the edge based on its five-year average annualized return. A more exhaustive look at the return history of the two funds also shows it holding the advantage, with a three-year average annualized return of 6.16%, compared to 4.87% for the iShares US Preferred Stock ETF, and a one-year return of 6.05%, which is substantially higher than the iShares ETF’s return of 2.91%.” according to Investopedia.
Alternatively, investors may also consider the PowerShares Variable Rate Preferred Portfolio Fund (NYSEArca: VRP) in a rising rate environment. Variable-rate preferreds usually trade more like bonds with shorter durations, so more conservative investors may find the lower-risk profile more appealing.
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iShares U.S. Preferred Stock ETF
