In the low interest rate environment of the past several years, preferred stock was popular with investors who wanted higher yield. That's because preferred stock is a hybrid vehicle that combines features of debt, in the form of fixed dividends, and equity, with the potential for price appreciation. Owners of preferred stock have priority over common shareholders regarding dividend payouts.
And a new preferred-stock exchange-traded fund debuted this month, coming on the heels of the Federal Reserve’s September meeting where the Fed continues its attempts to normalize monetary policy. That product is the Global X U.S. Preferred ETF (PFFD), which tracks the BofA Merrill Lynch Diversified Core U.S. Preferred Securities Index. Its expense ratio is 23 basis points, making it the cheapest preferred-stock ETF available. ETFdb.com counts 14 preferred-stock ETFs, with an average expense ratio of 55 basis points.
PFFD is the second preferred-stock ETF from Global X, which also has SuperIncome Preferred ETF (SPFF). That fund has an expense ratio of 58 basis points, a yield of 7.04 percent and is up 3.69 percent year-to-date. Of the various preferred-stock ETFs, SPFF has the best yield, but lags the pack in performance terms.
The year-to-date returns on most preferred-stock ETFs have ranged between 8 percent and 10 percent, and yields range between 4.12 and 6 percent. The best performer is an international preferred-stock ETF, the iShares International Preferred Stock ETF (IPFF), up 22.5 percent year-to-date. Its yield is 4.12 percent.
Tim Clift, chief investment strategist at Envestnet | PMC, says that since interest rates may rise in coming months, financial advisors looking to add these ETFs to the income side of a client’s portfolio need to see what type of preferred stock the ETF holds.
“We know that preferred stocks have an inverse relationship with rising rates, they typically go down [when rates rise]," Clift says. "And the longer the maturity of these products, the more interest-rate sensitive they are.”
There are two main types of preferred stock. One type is perpetual preferred stock, which are the more interest-rate sensitive because they don’t have a maturity date, Clift says. The other type is floating-rate preferred stock, which reset during a specific timeframe—usually 90 days. They’re based on the Libor rate, and since these stocks are constantly being adjusted, rising rates have less of an effect.
Clift says the floating-rate preferred stocks have become more popular in the past few years, and he estimates they make up about 60 percent of the market. Still, he says, perpetual preferred stock is attractive because of the higher yield, and investors have been drawn to this category for that yield.
Since the Fed has communicated often their plans to raise rates, and with the market expecting one this year and maybe two or three in 2018, Clift believes the impact on preferred stock will likely be muted.
“The bigger concern is if you have a big spike in interest rates," he says.