One of the biggest reasons investors like preferred stocks and the corresponding exchange traded funds, such as the PowerShares Preferred Portfolio (NYSEArca: PGX) is yield. Put simply, preferreds and the ETFs that hold them usually sport far higher yields than are found on standard bond investments, but for PGX, that is changing.
However, the change is not a negative. It simply results in a smaller yield on the ETF. PGX, which is over nine years old, tracks the BofA Merrill Lynch Core Plus Fixed Rate Preferred Securities Index. The ETF holds 251 preferred stocks.
“A key measure of the yield for the exchange-traded fund’s underlying index plunged by nearly 3 percentage points on March 22. The change came because the index switched the way it calculates the metric known as yield to worst, which indicates the investor’s income from the fund in a worst-case-scenario,” reports Carolina Wilson for Bloomberg.
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.
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 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 multiple 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.
“The big decline in potential returns in Bank of America’s index stemmed from the yield-to-worst measure, which represents the yield investors would receive if issuers bought back their securities at face value en masse as soon as they were eligible to, instead of continuing to pay dividends at their current levels. That measure dropped to 2.28 percent on March 22 from 5.05 percent the day before,” according to Bloomberg.
PGX currently has a distribution rate, a metric widely followed by retail investors, of almost 5.6%, according to issuer data.