Preferred stocks and exchange traded funds, such as the the iShares S&P US Preferred Stock Index Fund (NYSEArca: PFF), the largest preferred stock ETF, are among the high-yield, income-generating asset classes that have recently come under pressure as investors price in rising odds that the Federal Reserve will finally boost interest rates next month.
Preferred stocks are a type of hybrid security that show bond- and equity-like 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 don’t usually enjoy capital appreciation on par with common shares.
Still, income investors should be careful about being too eager to dump preferreds simply because one rate hike appears imminent. In fact, some market observers argue that the recent decline by preferreds is creating value in the asset class.
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. Although VRP is a lower duration product, it does yield over 5%.
“Investors should expect preferred securities to be one of the more volatile fixed-income asset classes, and this volatility must be accepted as a tradeoff for the potential of higher yields inherent in the sector,” according to a Wells Fargo Investment Institute note posted by Amey Stone of Barron’s.
Income investors have looked to preferred stock ETFs in their portfolios for a number of reason. For instance, the asset class offers stable dividends, does not come with taxes on qualified dividends for those that fall into the 15% tax bracket or lower, is senior to common stocks in the event liquidation occurs, is less volatile than bonds and provides dividend payments before common shareholders.
“If investors are uncomfortable with the recent preferred-stock price decline, they may be over-allocated to the sector. For investors who are more comfortable with the potential volatility in the sector, we advise holding the course in the near term. Preferred securities can provide meaningful income, and we expect this sector to continue doing so,” according to the Wells Fargo note seen in Barron’s.
iShares S&P US Preferred Stock Index Fund (NYSEArca: PFF)
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.