An Attractive Entry Point into Preferred Stock ETFs

Preferred stocks and related exchange traded funds retreated along with other income-generating assets as U.S. yields spiked in response to the Federal Reserve’s tighter monetary policy, but the asset category may offer an attractive buying opportunity after the pullback.

“Preferred stocks have recently underperformed given their sensitivity to higher interest rates,” according to a BlackRock research note. “The sector now offers more attractive risk-adjusted opportunities after this period of weakness.”

For instance, the iShares U.S. Preferred Stock ETF (NYSEArca: PFF) has dipped 1.5% since the presidential elections as yields on benchmark 10-year Treasury notes jumped as high as 2.597%.

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.

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.

However, despite the Fed’s plans to hike interest rates three more times this year, we may still be in for an extended low-rate environment as many risks could keep a lid on yields and support safe-haven demand for fixed-income assets.