The Federal Reserve appears to be on course to raise interest rates for the first time this year next month, but even if that happens, the shocks to higher-yielding, income-generating asset classes should be limited because U.S. rates will still reside near historical lows.
International government bond yields have been depressed to near zero levels, with Germany 10-year yields down 45 basis points and Japanese 10-year yields dipping into the negative territory, while yields on 10-year Treasury bonds were hovering around 1.83%. Consequently, international fixed-income investors may be steering toward higher-yielding U.S. Treasuries, which may help put a lid on rising rates in the U.S.
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However, inflation is a focus of the Fed and so is a possible interest rate hike, two scenarios that could test investors’ appetites for preferred ETFs, such as the iShares U.S. Preferred Stock ETF (NYSEArca: PFF) and the PowerShares Preferred Portfolio (NYSEArca: PGX). Still, some market observers viewed preferreds as a powerful tool for boosting a portfolio’s income and yield.
“Preferred securities currently remain among the highest-yielding fixed-income sectors today—an attractive proposition in a low-rate environment that we believe is likely to persist,” according to a Wells Fargo note posted by Amey Stone of Barron’s. “In our view, the main attraction for investors in owning preferred securities should not be price appreciation. Rather, the focus should be on potential income generation… At current levels, the sector appears to be fully valued from a price valuation perspective.”
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.
[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 interest rate risk.
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Wells Fargo’s Brian Rehling “doesn’t think investors should overdo it. In fact, over a year ago he told Barron’s that investors shouldn’t fall in love withe preferreds. At that point his firm recommended preferreds make up 11% of a fixed-income portfolio, or not more than 3-4% of a total investment portfolio,” according to Barron’s.
For more information on Fixed-Income ETFs, visit our Fixed-Income category.
iShares U.S. Preferred Stock ETF
