Different Ways To Play Preferreds

Different Ways To Play Preferreds

With the murky outlook for equities and bonds, preferred stock could generate income with lower volatility.

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Reviewed by: Jessica Ferringer
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Edited by: Jessica Ferringer

Equity markets have been on the rise since last spring, bouncing back from bear market levels at the fastest pace on record. However, with worries about the delta variant and rising inflation concerns, the outlook for equities going forward is mixed.

The bond market is under pressure as well, with long-term yields dropping over the last several weeks in spite of the Fed’s projection that the central bank might need to raise rates sooner than initially expected.

With an uncertain outlook for both the equity and bond markets, preferred stocks could be a way for investors to access income with lower volatility than stocks or high yield bonds.

Preferred stock is similar to common stock in that it represents a piece of ownership in a company. However, it generally has no voting rights. In exchange for giving up these voting rights, preferred shareholders are given priority over common shareholders in terms of dividends as well as company assets in the event of bankruptcy.

This dividend stream makes it comparable to the income stream for a bond, meaning these preferred shares exhibit some interest rate sensitivity. And similar to some bonds, preferred stocks can be called early by the issuer, usually at a premium to the par value.

Two Types Of Preferred Stocks

Not all preferred stocks are the same. Some are cumulative, meaning the issuer is required to pay any deferred dividend payments to the shareholder in the future before issuing other dividends. Noncumulative preferred stocks, on the other hand, do not have this stipulation, but often offer higher yields in exchange.

Adding to their appeal, qualified dividends from preferred stocks are taxed at the lower capital gains rate relative to bond interest, which is taxed as ordinary income.

There are several ways for investors to play the preferred market through ETFs.

The iShares Preferred and Income Securities ETF (PFF) tracks an index of preferred stock traded on the NYSE and Nasdaq. The fund targets preferred securities without regard to credit rating. Meanwhile, the Virtus InfraCap U.S. Preferred Stock ETF (PFFA) is actively managed and may use leverage to varying degrees—it’s at the other end of the spectrum from PFF’s beta exposure.

PFF has significantly more assets, coming in at $19.7 billion versus just $456 million for PFFA. The cost differential is significant as well, in terms of both expense ratio and spread. As shown on our ETF Comparison Tool, PFF is less than a third of the cost of PFFA.

 

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Although the cost differential here is significant, PFFA’s use of leverage can lead to outsized returns that more than make up for the cost.

 

Chart courtesy of StockCharts.com

 

Year-to-date, PFF has gained 3.9%, outperforming the broad fixed income market as represented by the iShares Core U.S. Aggregate Bond ETF (AGG). The broad-based fixed income benchmark is negative for the year due to rising yields in the first few months, spurred by optimism around reopening as well as inflation fears.

While PFF has significantly underperformed domestic large cap equities, as represented by the SPDR S&P 500 ETF Trust (SPY), the leverage within PFFA has allowed it to outperform SPY by 1.4% year-to-date.

Leverage doesn’t only amplify returns on the upside, however.

 

Chart courtesy of StockCharts.com

Preferred stocks fell during the market drawdown last year. PFF did outperform relative to SPY during the market downturn, exhibiting the protective quality of this asset class. However, PFFA fell by nearly 57% in the first three months of the year.

To Leverage Or Not?

Since leverage amplifies both the ups and the downs, investors should consider what the market environment looks like going forward when deciding which preferred ETF might be the best fit for their portfolio.

Currently, preferred stocks offer attractive yields relative to Treasuries. Adding modest leverage to this asset class provides even more of a bump in yield. As of the end of the second quarter, PFFA offered an 8.1% 30-day SEC yield versus 4.2% for PFF.

Should preferred stocks continue to exhibit low levels of volatility as they have so far this year, a leveraged option such as PFFA could be a way for investors to access higher levels of income relative to other asset classes.

Contact Jessica Ferringer at [email protected]

Jessica Ferringer, CFA, is a writer and analyst for etf.com. She has 10 years of experience in investment research and due diligence, including helping to manage ETF portfolios. Jessica has a bachelor’s degree in economics from Lafayette College and an MBA from the University of Pittsburgh.