The True Risks Behind Preferred Stock ETFs

Investors in search of steady income from their portfolios often select preferred stockswhich 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 yieldsalong 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 some benefits, 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) and the First Trust Preferred Securities and Income ETF (FPE).

General Risks

A big risk of owning preferred 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, before preferred stockholders claim 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 $16.80 billion. The fund’s trailing 12-month dividend yield is 5.50%, and it has an expense ratio of 0.46%.

This ETF tracks the performance of the S&P U.S. Preferred Stock Index. Only 5% of its 501 portfolio holdings are outside of the United States and the ETF is heavily skewed toward the financial sector, with banking sector securities comprising 27.50% of its weight, diversified financial securities comprising 18.9%, and the insurance sector accounting for 10.30% of the portfolio weight. Utilities account for 14.1% 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 260 holdings, total net assets of $5.4 billion, and ticker symbol FPE. The fund has a trailing 12-month dividend yield of 5.35%. The fund is an actively managed ETF with an expense ratio of 0.85%.

Only 24% of ETF’s holdings are investment grade (BBB or higher). Speculative-grade investments, with ratings from BBB- through B-, account for 69.8% of the fund’s holdings, and 4.4% were unrated.

Risk-averse investors might also be concerned about this fund’s lack of diversification, as it has a heavy allocation toward the financial sector. Banks accounted for 40.1% of the fund’s portfolio weight, followed by insurance securities at 12%, and capital markets at 11.1%. There is an additional 11% of the fund’s assets invested utilities and 5.7% in the oil and gas sector.

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