By David Sterman

Paltry payouts on government bonds and bills have forced many investors to seek out dividend-paying common stocks, which in turn has pushed up their stock prices up and driven down their dividend yields--the average dividend-paying stock in the S&P 500 yields just 2.5%. And investment-grade corporate bonds offer little help with their average payout (with a duration of 2-5 years) of just 3.5%, which is well below the historical average.

What are yield-hungry investors to do? Some investors are turning to preferred stocks. Not only do their payouts often exceed 5%, but they offer the chance for solid capital appreciation if the stock market moves higher. Preferred stocks are a favorite vehicle for companies that have steady, predictable cash flows. If the going gets tough, these companies can temporarily defer payments to preserve cash. Bonds, on the other hand, come with tight restrictions and payment terms that can force a company into bankruptcy. Indeed, few companies actually halted dividend payments on preferreds during the economic downturn of 2008.

But doing due diligence on preferred stocks can be tricky because you need to assess the financial strength of the issuer and try to determine which way the stock price will move--if preferred stock packs a 6% yield but loses 10% of its value, you're in the red.

Various Options
Rather than trying to find the best choice, why not own the group? Thankfully, a handful of ETFs-with a combined $15 billion in assets under management-have emerged to aid investors. Each one offers a slightly different approach.

The iShares S&P U.S. Preferred Stock Index Fund (PFF) is the big dog of the category, with $9.4 billion in assets and a five-year operating history. This ETF's track record highlights the clear appeal of preferred stocks. The consistent payouts helped shares from falling as deeply as traditional common stocks: PFF fell 23% in 2008, while the average global stock fund fell 40% that year, according to Morningstar. Yet PFF has subsequently rallied in tandem with broader stocks.

This fund focuses solely on U.S. financial services firms, which is not as scary as it sounds because even though the major banks got creamed during the '08-'09 downturn, they've since been diligently working to shore up their capital bases. As a result, they're far better positioned to handle another deep economic crisis if one emerges. The fund wisely spreads its bets around with roughly 250 preferred stocks from 100 financial institutions.

Still, many investors have yet to re-embrace the big banks due to ongoing regulatory uncertainty before the Dodd-Frank legislation fully kicks in by 2014. That's why Van Eck last week rolled out a preferred ETF concentrated on assets in other U.S. industries. The Market Vectors Preferred Securities ex-Financials ETF (PFXF) will hold more than half of its assets in the preferred stocks of Real Estate Investment Trusts (REITs) and electric utilities (with industrial stocks and telecom stocks accounting for another combined 20% of the fund). Its 0.40% expense ratio is the lowest in its category.

Will this fund hold up well if the U.S. economy significantly weakens? The predominant exposure to REITs could spell trouble if the still-weak real estate sector is hit with another spike in vacancies.  As long as the economy muddles along in the current low-growth mode, that shouldn't be a concern.

Venturing Abroad
Three other ETFs in the category enable investors can buy a basket of foreign-based preferred stocks. The PowerShares Financial Preferred Portfolio (PGF) is quite similar to the iShares U.S. Preferred Stock Fund with one huge exception: Roughly 60% of its assets are tied up in European bank preferreds. Considering that many leading European banks may need to recapitalize as part of a broader European economic rescue package, such a focus could spell trouble for the preferreds, which may either see their payouts sharply reduced or wiped out completely.

This ETF's 6.7% yield is almost 100 basis points higher than the U.S bank-focused iShares ETF, but that might not be enough to compensate for the risk. The fairly high 0.66% expense ratio is another concern, eating into whatever yields the fund offers.  The fact that PGF is already up more than 15% in 2012 seemingly ignores the considerable European economic headwinds that remain.

The iShares S&P International Preferred Stock Index Fund (IPFF), which launched last November, derives roughly 75% of its global exposure from Canadian firms-especially banks. That's comforting because Canadian banks largely eschewed the lending excess of the last half-decade and emerged from the downturn in far more stable condition. The fairly short existence of the fund helps explain low daily trading volumes of just 19,000 shares a day, and it's too soon to gauge how this fund will perform. It's up nearly 3% in the past eight months, though it will need to develop a longer track-record to gain more followers. And the same can be said for the recently-launched Van Eck fund, as well as two funds from Global X with short track records.

The Global X Canada Preferred ETF (CNPF), which has been up and running since May 2011 and also focuses on Canadian banks, has been fairly volatile. It fell roughly 10% in its first five months before rebounding somewhat (though it's still underwater). Don't let that scare you. The sell-off has a lot more to do with investors' fickle mood towards stocks in general and global banks in particular than the underlying health of Canadian banks and their ability to support preferred stock dividends. Over time, the focus on financially strong banks should reap solid gains.

Higher Risk/Higher Yield Potential
While most of the ETFs that focus on preferred stocks aim squarely at the middle of the market-those that offer moderate risk and mid-range yields-Global X this month launched the Global X SuperIncome Preferred ETF (SPFF) that amps up the return in exchange for a bit more risk by targeting the highest-yielding preferred securities in North America.

These stocks are the sector's equivalent of high-yield or "junk" bonds, which are typically offered by firms with less-than-stellar credit profiles. This ETF's holdings offer such juicy yields precisely because they are seen as vulnerable if the economy hits the skids.

It's worth noting that even in tough times, preferred dividends are rarely eliminated, but are just deferred.  And when financial results improve, the issuer must make up for the lost dividends before it can resume any regular (non-preferred) dividend payments on the common stock.

A peek at SPFF's 47 holdings offers a mixed bag of rock-solid issuers (Wells Fargo, Prudential Financial, and Aegon)  as well as riskier firms that already showed deep vulnerability in the last downturn (AIG, GMAC, Credit Suisse).  Yet no one issuer brings too much default risk: The top 10 holdings in the ETF represent just 17% of the total base of assets.

The fund's holdings, while passively-managed, will rotate to reflect the alterations made to the S&P Enhanced Yield North American Preferred Stock index. So this ETF's holdings will change twice a year, in April and October.  The current yield is around 7.5% (based on the index), well higher than the other ETFs profiled here, and the 0.58% expense ratio is in the mid-range of the pack. 

These preferred ETFs run the gamut in terms of risk and reward. The focus on European banks could spell trouble for the PowerShares fund (though conversely, a true stabilization package for Europe that doesn't force major haircuts for the European banks could spark a nice rally). If you want a hefty yield with less exposure to Europe, then the Global X SuperIncome Preferred ETF looks like a solid choice.

At the other end of the spectrum, the Canadian-focused funds likely offer lower risk, which explains the mediocre yields below 4%. If the soon-to-be-launched Market Vectors ETF can offer a yield approaching 6%, then it might become a popular choice. For now, the iShares U.S. Preferred Stock Fund, yielding nearly 6%, seems to offer the best risk/reward trade-off.


David Sterman has worked as an investment analyst for nearly two decades. He was a senior analyst covering European banks at Smith Barney and was research director for Jesup & Lamont Securities. He also served as managing editor at and research director at Individual Investor magazine.