When higher-yielding assets were in style earlier this year, income investors embraced 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.
However, higher-yielding assets have rapidly fallen out of favor and PFF has tumbled more than 3% over the past month as investors have sought other avenues of income amid speculation the Federal Reserve could still proceed with hiking interest rates in the near- term.
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.
SEE MORE: An Exceptional Preferred Stock ETF for Yield-Seeking Investors
While preferred stocks provide investors with an attractive source of yields, 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.
“When the curve steepens, the prices of fixed-to-floats fall. The reason for this is the disconnect between the coupon benchmark (three-month LIBOR) and the trading benchmark (long-dated U.S. Treasuries). When yields on the long end of the curve rise faster or independent of short-term yields, the yield on fixed-to-floats rise without a commensurate increase in coupon. The result is a price decline,” according to a Wealth Strategies & Management note posted by Amey Stone of Barron’s.
[related_stories]Other well-known preferred ETFs include the PowerShares Preferred Portfolio (NYSEArca: PGX) and the Global X SuperIncome Preferred ETF (NYSEArca: SPFF).
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%.
iShares S&P US Preferred Stock Index Fund
