Preferred ETFs

04/03/2015 9:00 am EST

Focus: ETFs

Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

ETFs that invest in preferred stocks have some of the highest yields available, surpassing those of virtually all stock and many high-yield bond ETFs, observes Mark Salzinger, editor of The Investor's ETF Report.

Preferred securities occupy a middle ground in corporate credit structure. Unlike a bond, preferred stock rarely carries any guarantee that principal will be returned and gives the owner no claim on assets if its issuer defaults.

Preferred stock also has no set date of maturity. Unlike common stock, preferred stock tends to have no voting rights, but preferred dividends must be paid before dividends to common shareholders.

Besides having lower standing in corporate credit structure, preferred securities can be callable by the issuer and their interest or dividend payments can be deferred in the case of financial difficulties.

Essentially, they are subject to the same market, interest-rate, and credit risks of bonds and high-yielding stocks. To compensate for this unique combination of risks, preferred stocks typically yield far more than common stock.

Preferred securities suffered significantly in 2013 as interest rates rose, but rebounded in 2014 as interest rates fell and the economy continued its measured improvement.

Over the past several years, the performance of preferred stock ETFs has been roughly comparable to the performance of high yield bond ETFs.

Preferred stocks can continue to perform well so long as the US economy continues to grow. They are especially dependent upon positive economic trends because the vast majority of preferred issuers are financial institutions.

Our favorite preferred stock ETF is PowerShares Preferred (PGX). Although it is not the largest such ETF, it has a sizable asset base of about $2.7 billion. As such, it has a suitably narrow bid/ask spread, generally a little more than 1/10 of 1% of its share price.

PGX also recently had the highest yield of any preferred ETF, at 5.9%. Be aware, though, that our positive view on this could change were we to expect interest rates to increase significantly.

Also of interest is relative newcomer First Trust Preferred Securities and Income (FPE), an ETF that is actively managed.

Its managers have tilted the fund toward shorter duration securities as those with greater interest-rate risk have outperformed, because they see more value in protecting against rising rates than in chasing the fattest possible yield.

They expect banks, especially, to continue to be significant issuers of preferred securities in an effort to comply with stricter capital requirements and lower leverage ratios. FPE recently yielded 5.8%.

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