By John Hyland
Before I began with ETFs in 2005, I was a mutual fund portfolio manager specializing in REITs and CMBS. I also ran money investing in preferred stocks. And I think that preferred stock ETFs are worth a close look right now.
For the first time in more than a decade, yield-oriented investors are looking at 5% plus on T-Bills, CDs and other low-risk vehicles. But they have a major problem. That problem is the fact that we have an inverted yield curve. This means although you can get 5.5% in a very low-risk investment, you can only lock that rate up for a year or so. If you decide to lock it up for several years, then your yield drops a fair bit. This is true even if you buy longer-term Treasuries or if you accept the credit risk and purchase high-grade bonds, mortgage-backed securities, or the bond ETFs that invest in them.
The second reason is their current yields and the ability for those yields to continue. The current yield on most of the actively quoted preferreds is in the 6.5% to 8.5% range depending on the credit rating of the issuer. That’s very attractive if we are in an environment where the Fed is going to allow rates to drift down.
Equally important is after the two-year fall in prices due to the Fed action, the bulk of preferred shares are trading below their call price. And those from higher-rated issuers are trading at an an average of 15% below the call price. As a result, the corporations that issued them are not going to be looking to call them back anytime soon. And when they do, there should be a nice capital gain to compensate for the loss of the high dividend.
Choosing Your Preferred Stock ETF
There are about two dozen preferred stock ETFs with roughly $28 billion in AUM. Five are in the $1 billion or more AUM range. It is not a huge market, but respectably sized with expense ratios the 40-basis point to 60-basis point range. Most of the larger preferred stock ETFs hold hundreds of issues. As a result, there is a large degree of credit risk diversification.
Because of my experience running a preferred portfolio through the 2008 financial crisis, I have a bias against portfolios based on indexes that do not take into account the creditworthiness of the individual preferred issuer and simply go with a market capitalization approach. I see a further problem with such indexes if they allow concentrated bets at either the single company level or in a particular sector. I favor actively managed preferred stock ETFs or, at a minimum, passive ETFs with indexes that explicitly take into account creditworthiness and cap issuer and sector concentrations.
If in 2007 and 2008, you simply owned the entire universe based on market capitalization without regard to credit issues or sector concentration — as some index-based preferred ETFs currently do — your four largest holdings were FannieMac, FreddieMac, Lehman Brothers and Bear Sterns. That did not work out well in 2008.
An active manager could have foreseen problems with those issuers by 2007 and done something. I am no Warren Buffett, but I held zero weights in these major issuers. That was a massive bet versus the benchmarks. All preferreds took a hit in 2008, but most recovered, except for some of those four names. It paid to be active and selective. I don’t foresee a looming bloodbath in this space, but I also don’t know that you get paid to be fully passive here.
Concluding Thoughts
There are two final considerations investors should take into account. First, some preferred stocks pay floating or variable dividend amounts. If you want to lock in current yields, you would steer away from ETFs that specialize in such preferreds.
Second, a portion — often a large portion — of the dividends from a preferred stock ETF will be claimed as qualified dividends. That means if you own the ETF in a taxable account and you are normally in a high tax bracket, you will pay taxes on the dividends at a lower rate. That’s nice bonus, although I suspect many individual investors will invest in these ETFs via their IRA or 401(k).
For more news, information, and analysis, visit VettaFi | ETF Trends.