Investors in search of steady income from their portfolios often select preferred stocks, which combine the features of stocks and bonds, rather than Treasury securities, corporate bonds, or exchange traded funds that hold bonds.Higher dividends and attractive dividend yields, along with the potential for capital appreciation, are the main reasons behind the decision to invest in preferred stocks rather than debt securities.
Another advantage of owning preferred shares rather than bonds is that their dividends are taxed as long-term capital gains rather than income, while the interest from Treasuries and corporate bonds are subject to ordinary income tax rates (which are typically lower than longer-term capital gains rates for many taxpayers). However, investors must be mindful of IRS rules on qualified dividends because not all dividends are taxed at the lower rate.
Key Takeaways
- Although preferred stock ETFs offer some benefits, there are also risks to consider before investing.
- Share prices of preferred stocks often fall when interest rates move higher because of increased competition from interest-bearing securities that are deemed safer, like Treasury bonds.
- Call risk is also a consideration with some preferred stocks because companies can redeem shares when needed.
- PFF and FPE are examples of exchange traded funds that hold shares of preferred stock.
- Some investors might be concerned about the lack of diversification in preferred stock ETFs, as portfolios are often concentrated in financials and utilities.
Although preferred stocks can offer somebenefits, these investments also have risks. We review those risks here and also take a look at two popular preferred stock ETFs: the iShares U.S. Preferred Stock ETF (PFF) andthe First Trust Preferred Securities and Income ETF (FPE).
General Risks
A big risk of owningpreferred stocks is that shares are often sensitive to changes in interest rates. Because preferred stocks often pay dividends at average fixed rates in the 5% to 6% range, share prices typically fall as prevailing interest rates increase. For example, if Treasury bond yields increase and approach a preferred stock’s dividend yield, demand for shares will likely decline, sending its share price lower. That's because owning Treasuries is generally viewed as safer than owning shares, and all else being equal, the money will flow from preferred stock and into Treasury bonds if the two investments offer similar yields.
Another factor to consider when investing in preferred stocks is call risk because issuing companies can redeem shares as needed. This can happen with callable preferred stock when interest rates fall—the issuing company may then redeem those shares for a price specified in the prospectus and issue new shares with lower dividend yields.
Like with common stock, preferred stocks also have liquidation risks. If a company is bankrupt and must be liquidated, for example, it must pay all of its creditors first, and then bondholders, beforepreferred stockholdersclaim any assets.
Particular Risks
Preferred stocks are rated by the same credit agencies that rate bonds. The top three rating agencies are Moody’s, Standard & Poor’s, and Fitch Ratings. While preferred stocks can earn an investment-grade rating, many have ratings below BBB and are considered speculative or junk.
Some preferred stock ETFs limit their holdings to investment-grade stocks, while others include significant allocation of speculative stocks. The cautious investor must become familiar with the particular investment strategy and portfolio holdings of the ETF.Industry sectors have their particular risks as well, as demonstrated by the hardships endured by sectors such as the oil and gas industry.
iShares U.S. Preferred Stock ETF
Listed under the ticker symbol PFF, iShares U.S. Preferred Stock and Income Securities ETF is the largest preferred stock exchange-traded funds, with total assets of $13.23 billion. The fund's trailing 12-month dividend yield is 7.36%, and it has anexpense ratioof 0.46%.
This ETF tracks the performance of the S&P U.S. Preferred Stock Index. The 455 portfolioholdingsof the ETF are heavily skewed toward the financial sector, with banking sector securities comprising 37.20% of its weight, the insurance sector accounting comprising 13.70%, and the real estate investment trust accounting for 13.20% of the portfolio weight. Electric accounts for 10.90% of the portfolio.
The concentration in financials and utilities and subsequent lack of diversification of some preferred stock ETFs, like PFF, could alienate a significant number of risk-averse investors beyond those who fear another financial crisis.
First Trust Preferred Securities and Income ETF
Of the major preferred stock ETFs, the First Trust Preferred Securities and Income ETF is one of the largest, with 253 holdings, total net assets of $5.26 billion, and ticker symbol FPE. The fund has a trailing 12-month dividend yield of 6.53%. The fund is anactively managed ETFwith an expense ratio of 0.85%.
Only 32.19% of ETF's holdings areinvestment grade(BBB or higher). Speculative-grade investments, with ratings from BBB- through B+, account for 51.72% of the fund’s holdings, and 3.37% were unrated.
Risk-averse investorsmight also be concerned about this fund’s lack of diversification, as it has a heavy allocation toward the financial sector. Banks accounted for 42.71% of the fund's portfolio weight, followed by insurance securities at 19.34%, and the oil and gas sector at 8.59%. There is an additional 7.19% of the fund’s assets invested capital markets and 4.42% in the multi-utilities.
As an experienced financial analyst with a deep understanding of investment instruments, particularly preferred stocks and exchange-traded funds (ETFs), I bring valuable insights to help you navigate the complexities of this financial landscape.
Preferred stocks, as highlighted in the provided article, are a hybrid investment that combines features of both stocks and bonds. Investors often turn to preferred stocks for their higher dividends, attractive dividend yields, and the potential for capital appreciation. One notable advantage over traditional bonds is the favorable tax treatment of preferred stock dividends as long-term capital gains.
However, my expertise extends beyond the general advantages. Let's delve into the concepts mentioned in the article:
1. Preferred Stocks: General Risks
- Interest Rate Sensitivity: Preferred stocks are sensitive to changes in interest rates. As interest rates rise, the fixed-rate dividends of preferred stocks may become less attractive, leading to a decline in share prices.
- Call Risk: Some preferred stocks are callable, meaning the issuing company can redeem them if interest rates fall. This introduces the risk of having shares redeemed at a specified price.
2. Preferred Stocks: Particular Risks
- Credit Ratings: Like bonds, preferred stocks are rated by agencies such as Moody’s, Standard & Poor’s, and Fitch Ratings. Ratings below BBB are considered speculative or junk, indicating higher risk.
- Industry Sector Risks: The article highlights the specific risks associated with industry sectors. For instance, the oil and gas industry has faced hardships, affecting related preferred stocks.
3. iShares U.S. Preferred Stock ETF (PFF)
- Overview: PFF is the largest preferred stock ETF, tracking the S&P U.S. Preferred Stock Index.
- Assets and Dividend Yield: Total assets of $13.23 billion with a dividend yield of 7.36%.
- Expense Ratio: PFF has an expense ratio of 0.46%.
- Sector Concentration: Heavy concentration in the financial sector (37.20%), insurance (13.70%), and real estate investment trusts (13.20%).
4. First Trust Preferred Securities and Income ETF (FPE)
- Overview: FPE is one of the largest preferred stock ETFs, actively managed with 253 holdings.
- Assets and Dividend Yield: Total net assets of $5.26 billion and a dividend yield of 6.53%.
- Expense Ratio: FPE has an expense ratio of 0.85%.
- Credit Quality: Only 32.19% of holdings are investment grade, while speculative-grade investments account for 51.72%.
- Sector Concentration: Significant allocation to banks (42.71%), insurance (19.34%), and oil and gas (8.59%).
In conclusion, while preferred stocks and ETFs can provide attractive income, it's crucial for investors to be aware of the associated risks, including interest rate sensitivity, call risk, credit ratings, and industry sector risks. Additionally, understanding the specific characteristics and concentrations of popular ETFs like PFF and FPE is essential for making well-informed investment decisions.
