The Federal Reserve could raise interest rates as soon as this month, but even if a hike of 50 basis points is deployed, rates will still be low on an absolute basis, meaning that fixed income investors are likely to remain hungry for yield.
One way of satiating that appetite is with preferred stocks and the related exchange traded funds, such as the American Century Quality Preferred ETF (QPFF). While some preferred ETFs are simply yield plays, the actively managed QPFF balances risks associated with preferreds.
QPFF “manages credit, liquidity, rate and other structural and market risks in an effort to deliver attractive yield and with potentially less downside,” according to American Century.
While the high yields offered by preferreds are alluring, particularly at a time of depressed yields on conservative bonds, it pays to remember that preferreds are hybrid securities, meaning that they have both equity and fixed income properties.
As is the case with high-dividend stocks, a high-yield preferred can be concerning because high yields can potentially be a sign of financial duress. Compounding that issue is the fact that preferred dividends aren’t like common stock payouts. A company can skip a common stock dividend payment to conserve cash, but it must pay preferred dividends or risk a credit downgrade.
“Higher yields may be appealing, but they almost always come with the additional risks described below. However, lower yields that other investments offer can also be risky—in terms of maintaining purchasing power, meeting living expenses and so on. So there are tradeoffs,” writes Collin Martin of Charles Schwab.
QPFF, which is just over a year old, had 125 holdings at the end of 2021. At that time, the ETF’s 30-day SEC yield was a tempting 4.67% with a spread duration of 2.58 years, according to issuer data. About 27.5% of the fund’s holdings carried junk ratings, and another 18% weren’t rated, but potential credit risks can be mitigated by the fund’s active management.
QPFF’s ability to manage credit risk and focus on quality is relevant to income investors because preferreds usually carry lower credit ratings than the issuer’s senior unsecured corporate debt.
“An issuer’s preferred securities will usually have a lower rating than the firm’s senior, unsecured bonds. Also, preferred securities are often compared to sub-investment grade, or high-yield, bonds, given the higher income opportunities. But remember, high-yield bonds, by definition, carry speculative-grade ratings, so they do come with credit risk,” concludes Martin.
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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.
