Taking Note Of A Prudent Preferred Idea | ETF Trends

As has been widely noted, common stock dividends on bank equities are in a holding pattern, or worse in some cases, following the Federal Reserve’s recent stress tests. While that ominous scenario may not matriculate to preferred stocks, the Principal Spectrum Preferred Securities Active ETF (CBOE: PREF) is an avenue for conservative investors to tap preferreds.

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.

“We believe the risk that preferred-stock dividends will be suspended is low despite the recent announcement by the Federal Reserve that it is requiring banks to cap their common stock dividends,” writes Collin Martin of Charles Schwab for Advisor Perspectives. “With the results of its 2020 Dodd-Frank Act Stress Test, the Fed issued rules on what banks can or can’t do with their income and how much can be used for shareholder-friendly activities, capping the amount that can be paid out as common-stock dividends. However, preferred-stock dividends were not included in those rules. We can’t rule out the risk of dividend suspensions longer term if the economic outlook deteriorates, but our current view is that the risk of industry-wide dividend suspension is low.”

Power of PREF

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.

In the current environment of declining common equity dividends in an array of sectors, PREF and the benefits of preferred dividends stand out.

“Many banks, and corporations in general, are hesitant to eliminate their common-stock dividends, as this may result in their being removed from certain indexes that only hold dividend-paying stocks. When this happens, investors who track these indexes are often forced to sell, usually resulting in lower stock prices. To prevent this from happening, many banks and corporations try to continue to pay dividends, even if it’s just one cent per quarter. But remember, even if the issuer wants to make that $0.01/quarter dividend, it must always pay all of its preferred-stock dividends first,” according to 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.