Preferreds Backed by Uncle Sam

01/19/2009 1:00 pm EST

Focus: ETFS

Bryan Perry

Editor, Cash Machine, Premium Income, Quick Income Trader, Instant Income Trader

Bryan Perry, editor of The 25% Cash Machine, says preferred stock issued by big banks is a good deal—because of the government’s backing.

One of the hottest themes of 2009 for big-cap money managers is to take a stake in high-yielding preferred stocks in companies backed by the Troubled Asset Relief Program (TARP). It seems the government has promised to “do whatever it takes” to breathe life back into the banking sector.

Preferred stocks were smoked with the credit markets in the latter part of 2008, to a point where the definition of “capitulation” was rewritten for all time. But investors are still attracted to preferreds because yields are near double digits, and famed investors like Warren Buffett are also investing their money there. In addition, governments around the world have taken equity stakes in troubled banks through preferred shares.

And now, with the TARP funds, fund managers have been legging into high-quality preferred shares backed by the nation’s largest banks. It sounds toxic, but these banks are now government-guaranteed to survive this recession. And they will come out the other side smelling like roses, no matter how long it takes.

So what strategy is the best? Investing in iShares S&P US Preferred Stock Index Fund (NYSEArca: PFF). About 90% of the portfolio’s assets are in the financial sector simply because banks and insurance companies are among the largest issuers of preferred shares. Accordingly, investors should be aware that most of their investment will be tied up in the troubled financial sector, and the real estate, materials, health care, and auto sectors.

As the credit markets recover, I think PFF will be a great investment. I believe PFF has ushered in a new up trend in the face of all the bad news. The ETF broke its multimonth down trend in late December after putting in a textbook double-bottom “W” formation, and then exploded out of that base on a gigantic rise in trading volume and money flow.

And talk about yield power! The preferred stocks that make up the holdings of this ETF are throwing off some serious yields, primarily because the economy is still retrenching. PFF has a 30-day yield of 9.3% and charges management fees of 0.48%. And I like the makeup of this portfolio—which includes Wells Fargo, Freeport-McMoRan Copper & Gold, Citigroup, and MetLife, to name a few—for a number of reasons, but mostly because the government is backstopping all these companies.

So the bottom line is that I’m expecting the credit markets to steadily improve from their capitulation levels over the next year, this ETF is in a new up trend, and I think that another 20% move higher from its current level at $28 is a done deal. Its 200-day moving average lies overhead at $36 where shares of PFF are surely going to run into technical resistance, but when shares reach that level, we will have achieved our one-year up side goal of 25%. Buy PFF under $33.

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