Preferred stocks and related exchange traded funds are, well, preferred destinations for income seekers in today’s low yield climate.
The Global X Variable Rate Preferred ETF (PFFV), which tracks the ICE U.S. Variable Rate Preferred Securities Index, is an optimal blend of above-average yields and short duration.
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.
Variable-rate preferreds usually trade more like bonds with shorter durations, so more conservative investors may find the lower-risk profile more appealing.
Why Preferred Stocks in Today’s Environment?
PFFV is a relevant consideration for income investors today.
“The sweet spot may be in allocating to asset classes that feature both low duration and high yield. Currently, variable rate preferreds and high yield bonds offer an attractive balance of lower duration and higher yield in the fixed income space,” notes Global X analyst Rohan Reddy. “Variable rate preferreds typically pay a fixed coupon for the first 5 to 10 years of the preferred’s lifecycle before paying a floating rate based on the London Interbank Offering Rate (LIBOR) plus a pre-determined credit spread. Therefore, as rates increase, their coupons adjust higher. High yield bonds tend to pay fixed coupons, but they are largely issued with intermediate (such as 5 year) maturities.”
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 interest rates low, investors can use PFFV as an income-generating instrument now. It also serves as a hedge against future rate hikes because fixed rate preferreds have longer durations.
“We favor variable rate preferreds due to extremely tight credit spreads on high yield bonds. High yield spreads ended 2020 at the same level they started 2020, 3.27%, despite substantially greater risks in the economy,” adds Reddy. “Variable rate preferreds, on the other hand, have higher overall credit quality than high yield bonds, with a BBB- rating at the index level compared to a B+ rating for high yield bonds – four notches higher. With the real economy is still on shaky footing, reaching too far into high yield credit could be costly.”
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