Preferred stocks are often viewed as a docile, low beta, income-generating asset class, but many of the assets with the same hallmarks are swooning this month, indicating active management, as offered by the Principal Spectrum Preferred Securities Active ETF (CBOE: PREF) is worth considering.
“Under normal circumstances, the fund invests at least 80% of its net assets, plus any borrowings for investment purposes, in preferred securities at the time of purchase,” according to Principal. “Examples of preferred securities include preferred stock, certain depositary receipts, and various types of junior subordinated debt (such debt generally includes the contractual ability to defer payment of interest without accelerating an immediate default event). It concentrates its investments (invests more than 25% of its net assets) in securities in one or more industries within the financial services sector.”
Preferred stocks are a type of hybrid security that shows 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.
PREF looks to outperform the ICE BofA US Investment Grade Institutional Capital Securities Index and among preferred ETFs, the Principal fund is focused with 38 holdings.
PREF Pluses
As an actively managed fund, PREF isn’t constrained by an index, meaning its managers can exploit opportunities passive funds in this category cannot.
For example, most passive preferred ETFs are focused on domestic issues, but PREF allocates almost 30% of its weight to ex-US bonds, according to issuer data. Additionally, PREF devotes over 13% of its weight to convertible bonds.
Convertible bonds are a type of hybrid fixed-coupon security that allows the holder the option to swap the bond security for common or preferred stock at a specified strike price. Due to the bond’s equity option, convertible bonds typically pay less interest than traditional corporate bonds. The fund, though, does not convert its holdings into shares, but investors are exposed to the equity premium due to the way the bonds are priced.
Income investors have looked to preferred stock ETFs in their portfolios for a number of reasons. 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.
With a distribution yield of 4.67%, PREF does, in fact, deliver the goods for income investors.
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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.