The Case For Preferred ETFs as The Fed Hits The Pause Button | ETF Trends

High-yield, income-generating assets and the related exchange traded funds are benefiting this year as many bond market observers speculate that the Federal Reserve will not raise interest rates. That includes preferred stocks and the VanEck Vectors Preferred Securities ex Financials ETF (PFXF).

Up almost 10% this year, PFXF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Wells FargoHybrid and Preferred Securities ex Financials Index. The Index is intended to track the overall performance of U.S.-listed preferred securities excluding those with a financial sector classification, including securities that, in Wells Fargo Securities LLC’s judgment, are functionally equivalent to preferred securities such as convertible securities, depository preferred securities and perpetual subordinated debt.

Like common stock, preferred stock is issued by a company and traded on an exchange. Preferred stock prices can fluctuate, but most of the returns from preferred stock come from dividends. Unlike common stock, preferred stock dividends are predetermined and paid at regular intervals. These dividends are paid in full before any dividends are released to common stockholders.

“Preferreds have historically offered higher yields than both common stock and senior debt,” said VanEck in a recent note. “Moreover, many pay qualified dividends, which are taxed at the capital gains rate rather than ordinary income, increasing the after-tax yield advantage of preferreds over traditional debt.”

Preferred Power

Preferred stock also acts like a bond. A par value is assigned on issue and this price rises or falls based on interest rates. When interest rates go up, the par value of the shares is diminished, just like bonds. Some preferred shares even have a maturity date where the investors’ capital is returned. Finally, some preferred shares are callable, meaning the company can decide at any time to repurchase the shares (although usually at a premium).

“Beyond higher yields, preferreds also have limited direct equity participation which may help minimize their volatility relative to common stock and help insulate investors from market drawdowns,” according to VanEck. “Additionally, with the Fed’s pause on rate hikes extended through year-end and expectations of future hikes lowered, price volatility related to interest rate risk may stabilize.”

Excluding financials, as PFXF does, has offered similar yield to the broad preferred securities universe, provided greater diversification since financials make up almost three quarters of the broad preferreds universe and generated lower volatility historically than with financial preferreds.

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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.