Last week, my colleague Alan Gula wrote about the “reach for yield” phenomenon, noting that preferred stocks have avoided the mania so far.
This is important, because searching for income has become extremely challenging in today’s environment.
But their unique characteristics could raise red flags for some investors.
So which ETFs present the best opportunity for income investors right now?
Generally speaking, preferred stocks are appealing to income investors – especially those in high tax brackets – because a majority of the dividends are “qualified” like common stock dividends.
That means dividends from preferreds are taxed at a maximum rate of 20%, rather than the 39.6% at which interest income is taxed. Thus, the yield is quite attractive.
Meanwhile, investing in a broad-based ETF of preferred stocks can help minimize risk and maximize income.
One reason is that preferred stock dividends are fixed, much like interest on a bond. In some cases, the preferred stocks are convertible into common stock, but the preferred stock ETFs generally invest in securities without conversion rights.
Meanwhile, preferred stock dividends carry a higher priority than common stock, and dividends must be paid to preferred stockholders first (though bonds still take priority over both).
Plus, many preferred stock dividends are cumulative, meaning if a company fails to pay the dividend in a particular year, it must make it up in subsequent years. For instance, Ford (F) failed to pay preferred stock dividends in 2009, but it paid them on top of regular dividends in subsequent years.
It’s also worth noting that the yield on a preferred ETF will vary marginally as underlying preferred stocks mature, or are sold and replaced with new holdings. Still, buying a preferred stock ETF is generally more satisfactory than buying individual preferred stocks – an ETF offers risk diversification and helps investors avoid the poor liquidity of many preferred stocks.
Breaking Down the Preferred Stock ETFs
The largest preferred stock ETF is the iShares U.S. Preferred Stock ETF (PFF), a chunky $13-billion fund that attempts to match the return of the S&P U.S. Preferred Stock Index. PFF has a below-average expense ratio of 0.47% and yields 6%.
The second-largest fund, the PowerShares Preferred ETF (PGX), is a still-sizeable $2.8 billion. It has an expense ratio of 0.5%, though it’s linked to the Bank of America Merrill Lynch Core Plus Preferred Securities Index. At 2.40% and 2.41%, the two funds are nearly identical in year-to-date performance, so choosing between them appears to be a coin flip.
A third indexed fund, the SPDR Wells Fargo Preferred Stock ETF (PSK), is linked to the Wells Fargo Hybrid and Preferred Securities Aggregate Index. It has a slightly lower expense ratio of 0.45% and a slightly better year-to-date performance at 2.51%. However, it’s just a $300-million fund, so it must be regarded as slightly riskier. It also has a somewhat lower yield at 5.2%.
Now, a large proportion of preferred stocks relate to financial services companies. Two funds segregate these out so that you can choose whether you want financial services preferreds or non-financial preferreds.
The PowerShares Financial Preferred ETF (PGF) is financial-only and has a somewhat higher expense ratio at 0.63%, while the Market Vectors Preferred Securities ex-Financials ETF (PFXF) has the lowest expense ratio at just 0.4%. PFXF also has the highest return of any indexed preferred at 2.71%. Given the amount of leverage in the U.S. system and the risk of another financial crisis, I’m more interested in PFXF.
Next are two other indexed ETFs, each with a specialized approach. The Global X SuperIncome Preferred ETF (SPFF) tracks the S&P Enhanced Yield North American Preferred Stock Index. SPFF has slightly underperformed this year (a return of 1.99%), but offers a higher running yield of 6.75%. However, higher yield comes with higher risk, so I’d avoid this one.
A more interesting alternative is the PowerShares Variable Rate Preferred ETF (VRP), which invests in variable rate preferreds issued by financial institutions. This offers a running yield of only 4.6% – but with interest rates having risen a touch, it’s produced a return of 2.87% this year, better than any other indexed fund. Since I expect interest rates to rise over the next year or so, I’d be tempted by this one, which should avoid the price decline you’d normally see in fixed-dividend preferred ETFs when rates rise.
Last among U.S. funds is the First Trust Preferred Securities and Income ETF (FPE), which isn’t indexed and attempts to pick the best preferred stocks. With a year-to-date return of 3.14% it appears to have done so successfully, though it also has the highest expense ratio at 0.85%.
Finally, there’s one international fund, the iShares International Preferred Stock Fund (IPFF). At $36 million in assets, this fund is very small. It also has the dubious distinction of a negative year-to-date return (-1.71%). You see, by investing in foreign (developed country) preferred stocks, this fund incurs currency risk. That being said, it’s only 53% in finance, while the rest is in real estate and energy around Western Europe and Canada. Thus, it may be worth considering if you believe the dollar will be weak.
So there you have it. The sector is attractive, and yields run in the 5% to 6% range. Personally, I would consider PFXF because of its avoidance of the financial sector and VRP because of its protection against a rise in interest rates. Regardless, though, a strong portfolio is bound to include some preferred stock ETFs.