A Preferred Idea for Income From the Financial Services Sector

Bank dividends and payout growth are under some stress, no pun intended, by way of the Federal Reserve’s recent stress tests. The results of that annual checkup could shine a light on preferred stock ETFs, including the Principal Spectrum Preferred Securities Active ETF (CBOE: PREF).

Bank stocks slipped last week as the Fed said no buybacks will be allowed by the largest U.S. banks and dividends are now capped. One of the primary takeaways from the Fed stress test is that it will be at least the fourth quarter before banks can boost payouts again. Second, some financial firms, including Capital One (NYSE:COF) and Wells Fargo (NYSE:WFC), are viewed as prime candidates for potential dividend cuts.

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.

Translation: limited or no dividend growth for common bank stocks isn’t necessarily a negative for a fund like PREF because less cash going out the door for common equity investors fortifies reserves for preferred payouts.

Another PREF Perk

Another benefit with PREF is that it’s actively managed, meaning it doesn’t have to feature the same level of devotion to preferred stocks issued by banks as do rival index funds in the preferred category.

In passive preferred ETFs, banks dominate at the sector level, a relic of the global financial crisis when banks issued preferreds to raise cash. Said another way, PREF can react more quickly to stress on bank balance sheets than its passive counterparts.

“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.”

PREF, which is up more than 11% in the second quarter, yields 4.82%.

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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.