The real risks behind preferred stock ETFs

Investors looking for stable income from their investment portfolios usually choose preferred stocks that combine the characteristics of stocks and bonds, rather than treasury bonds, corporate bonds, or exchange-traded funds that hold bonds. Higher dividends and attractive dividend yields, as well as the potential for capital appreciation, are the main reasons for deciding to invest in preferred stocks instead of debt securities.

Another advantage of holding preferred stocks instead of bonds is that their dividends are taxed as long-term capital gains rather than income, while interest on government bonds and corporate bonds are subject to ordinary income tax rates (usually lower than long-term capital gains). Many taxpayers The rate of return). However, investors must pay attention to the IRS’s regulations on qualified dividends, because not all dividends are taxed at a lower tax rate.

Key points

  • Although preferred stock ETFs provide some benefits, you also need to consider risks before investing.
  • Due to increased competition from interest-bearing securities that are considered safer (such as Treasury bonds), the stock price of preferred stocks usually falls when interest rates rise.
  • Bullish risk is also a consideration for some preferred stocks because the company can redeem the stock when needed.
  • PFF and FPE are examples of exchange-traded funds holding preferred shares.
  • Some investors may be concerned about the lack of diversification of preferred stock ETFs because their investment portfolios are usually concentrated in finance and utilities.

Although preferred stocks can provide some benefits, these investments also have risks. We reviewed these risks here and looked at two popular preferred stock ETFs: iShares US Preferred Stock ETF (PFF) and First Trust Preferred Securities and Income ETF (FPE).

General risk

One big risk of holding preferred stocks is that stocks are usually sensitive to changes in interest rates. Since preferred stocks usually pay dividends at an average fixed interest rate of 5% to 6%, the stock price usually falls as the prevailing interest rate rises. For example, if Treasury bond yields rise and approach the dividend yield of preferred stocks, demand for the stock may fall, causing its share price to fall. This is because owning U.S. Treasury bonds is generally considered safer than owning stocks, and other things being equal, if the two investments provide similar yields, funds will flow from preferred stocks into U.S. Treasury bonds.

Another factor to consider when investing in preferred shares is bullish risk, because the issuing company can redeem the shares as needed. This may happen to redeemable preferred shares when interest rates fall-the issuing company may then redeem these shares at the price specified in the prospectus and issue new shares with lower dividend yields.

Like ordinary shares, preferred shares also have liquidation risks. For example, if a company goes bankrupt and must be liquidated, before preferred shareholders can claim any assets, it must first pay all of its creditors and then bondholders.

Special risk

The ratings of preferred stocks are the same as the credit agencies that rate bonds. The top three rating agencies are Moody’s, Standard & Poor’s and Fitch Ratings. Although preferred stocks can receive investment grade ratings, many preferred stocks are rated lower than BBB and are considered speculative or junk stocks.

Some preferred stock ETFs limit their holdings to investment-grade stocks, while others include a large number of speculative stocks. Prudent investors must be familiar with the specific investment strategies and portfolio of ETFs. The industrial sector also has its own special risks, as evidenced by the difficulties experienced by sectors such as the oil and gas industry.

iShares U.S. Preferred Stock ETF

iShares U.S. Preferred Stock and Income Securities ETF is listed under the stock code PFF. It is the largest preferred stock exchange-traded fund with total assets of US$16.8 billion. The fund has a dividend yield of 5.50% over the past 12 months and an expense ratio of 0.46%.

This ETF tracks the performance of the Standard & Poor’s U.S. Preferred Stock Index. Only 5% of its 501 portfolio is outside the United States. ETFs are heavily biased towards the financial sector. Bank sector securities account for 27.50% of its weight, diversified financial securities account for 18.9%, and insurance sector account for 10.30% of its portfolio weight. Utilities accounted for 14.1% of the portfolio.

The concentration of finance and utilities and the subsequent lack of diversification of some preferred stock ETFs (such as PFF) may alienate a large number of risk-averse investors, rather than those who are worried about another financial crisis.

First Trust Preferred Securities and Income ETF

Among the major preferred stock ETFs, First Trust Preferred Securities and Income ETF is the largest one, holding 260 stocks, total net assets of 5.4 billion U.S. dollars, and the stock code is FPE. The fund’s 12-month dividend yield is 5.35%. The fund is an actively managed ETF with an expense ratio of 0.85%.

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

Risk-averse investors may also worry about the lack of diversification of the fund because it allocates a large amount of 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%. The fund also has 11% of its assets invested in utilities and 5.7% in the oil and gas industry.

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