How to invest in preferred stock ETFs

Preferred stocks perform more like bonds but can also provide income.

  • By Ellen Chang,
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Preferred stocks consistent dividend payments, but since they offer higher income payments than traditional bonds, these assets are a hybrid between stocks and bonds.

While preferred stocks represent ownership in a company similar to a stock, these equities function somewhere in between bonds and stocks for income-seeking investors, says Mitch Tuchman, chief investment officer at Rebalance, a California-based retirement provider.

"Most preferred stocks are issued by large financial institutions including the largest U.S. banks and insurance companies," he says.

Here are a few things to know about adding preferred stock exchange-traded funds to your portfolio:

  • Preferred stock ETFs perform more like bonds.
  • Funds are limited and concentrated in certain sectors.
  • Preferred stocks tend to be less volatile.
  • Interest rates affect returns.

Preferred stock ETFs perform similar to bonds

While preferred securities provide higher income payments compared with traditional bonds, these assets rank higher in the pecking order than common stocks if a bankruptcy occurred, says Todd Rosenbluth, head of ETF and mutual fund research at CFRA, a New York financial research company.

"iShares Preferred & Income Securities (PFF) and SPDR Wells Fargo Preferred Stock (PSK) are a couple of popular exchange-traded funds that provide diversified exposure to a range of companies and sectors," he says.

PFF's five-year return is 4.8% while its 10-year return is 6.7%; the fund carries an expense ratio of 0.46% The top holdings in the ETF include Broadcom (AVGO), Wells Fargo & Co. (WFC) and GMAC Capital Trust.

Preferred stocks are often considered to be more like bonds because they pay a consistent dividend like the coupons in bonds, says Derek Horstmeyer, an assistant finance professor at George Mason University.

"Their prices also act like bond prices, but one thing to be aware of is that a company's debt still has seniority over the preferred shareholders in the case of bankruptcy," he says. "This means if the company goes bankrupt, the debt holders will get paid first before the preferred shareholders."

If a bankruptcy occurred, bondholders would be repaid before preferred stock investors, but preferred stock investors would be ahead of common stockholders.

Since preferred stocks promise "to a certain degree" a known dividend income before common stockholders, the cumulative nature of the preferred dividend will provide extra income protection over time, says K.C. Ma, a finance professor at the University of West Florida.

"This is better than a conventional bond with a semi-annual coupon income which is not cumulative," he says.

Funds are concentrated in certain sectors

The universe of preferred shares is relatively small and concentrated in sectors like financials and utilities, says Rick Swope, vice president of investor education at E-Trade, a New York-based brokerage.

"Investing in a preferred stock ETF can provide diversification," he says.

Invesco Preferred ETF (PGX) is one example. Preferred stocks can provide income in a portfolio and preservation of capital.

"They're not always a sure thing, so understanding your risk tolerance is key," he says.

These stocks are mainly issued by financial institutions like banks due to the favorable treatment with regulators compared to traditional debt, says Rohan Reddy, a research analyst at Global X ETFs, a New York-based provider of ETFs.

"Since banks are on more stable footing today in the wake of the financial crisis, most preferred stock issuers offer better credit ratings than issuers in the high yield bond market," he says.

Preferred stocks tend to be less volatile

Preferred stock generates higher returns while lowering risk, Tuchman says.

"Ultimately, that means more money for people's retirement," he says. "These have been bleak years for income investors. No one has known where to put their money and earn a decent return with interest rates at 35-year lows and inflation eating away at portfolio values."

Preferred stocks generally offer superior yields to bonds and common stock dividends and are less volatile than common stocks, Tuchman says.

"While bond interest is taxable at personal income-tax rates, preferred stock dividends are taxed at preferential long-term capital gains rates," he says.

Bond coupons are usually taxed at ordinary income tax rates, experts say. While preferred stock dividends often come with favorable tax characteristics and are classified as qualified dividends. The maximum long-term capital gains rate is 20%, depending on taxable income and filing status.

Preferred stock ETFs are a good investment option for investors funding their retirement accounts because they offer income features of a fixed dividend, says Stuart Michelson, a finance professor at Stetson University.

Several preferred stock ETFs generate excellent annual returns, with dividend yields of more than 5% and low expense ratios, he says. He adds these ETFs can provide investors with great diversification.

The Invesco Preferred ETF has a 0.52% expense ratio, 5.4% dividend yield and a year-to-date return of 16.2% while the First Trust Preferred Securities & Income ETF (FPE) has a 0.85% expense ratio, 5.4% dividend yield and a year-to-date return of 15.7%, to name a couple of examples.

Interest rates affect returns

Since preferred stocks mimic conventional bonds, these equities are also more sensitive to interest rate risk, Ma says.

"When the interest rate rises, the value of any fixed-income investments will drop, as investors have a better outlet for a higher return somewhere else," he says. "In exchange for the dividend-income priority, preferred stocks usually do not have voting rights, and also callable like bonds."

Preferred securities are one asset class that can be a "useful part of an investor's portfolio in an environment that is starved for income," Tuchman says.

"As long as interest from high-quality debt such as U.S. government bonds is depressed, it's reasonable to seek better returns from income investments that offer those returns at a reasonable level of risk," he says.

Investors can easily combine other investment goals with protective income to invest in a special purpose preferred stock ETFs, Ma says. The InfraCap REIT Preferred ETF (PFFR) has a 19.5% year-to-date return while the Global X US Preferred ETF (PFFD) has a 15.5% year-to-date return. Invesco Financial Preferred ETF (PGF) has a 12.3% year to date and the Innovator S&P Investment Grade ETF (EPRF) has a 17.8% year-to-date return.

Investors are often on the hunt for more income, especially as they get closer to retiring. Preferred stocks tend to pay higher coupons than most bonds, so investors looking for yield may consider these assets when looking for income investments, Reddy says.

"Preferreds are often underrepresented in most fixed-income portfolios, so investing in preferreds is a way to diversify an investor's fixed-income portfolio as well," he says.

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