Preferred ETF Delivers High Yield and Rally Simultaneously

The iShares S&P U.S. Preferred Stock Index ETF (PFF) has been delivering strong share price appreciation of late while delivering outsized dividend distributions.  Over the prior 1 month period, PFF is up 5% compared to a 3% return for the S&P500.  If utilizing Financials as a proxy, the ETF XLF is also up 5%, but the yield on XLF is rather average at 2.5% vs the 8.5% that PFF sports.

Why are Preferred Stocks Rallying?

Preferred shares don’t perform exactly in line with equity returns.  Since the imminent collapse of the entire global financial system is no longer viewed as a viable outcome (at least near term), preferred stocks have really come off their lows with rigor.  The US and other governments demonstrated their commitment to prevent the collapse of those “too big to fail” and with that government backstop, coupled with a global equities rally, it’s become more evident that the underlying holdings are that much less likely to default on their debt obligations.

Given the insatiable demand for high yield right now in light of the paltry returns on Treasuries (see how to Short Treasuries), even the highest yield savings accounts and other conventional vehicles, even retail investors are taking a hard look at preferreds, high yield corporate bonds, business development companies and other niche investment vehicles.

Preferred ETF Dividend Pays Monthly

PFF pays dividends monthly which is a nice benefit from several aspects.  First and foremost, dividend reductions are more timely and ordered, and less apt to leave retail investors holding the bag if institutional investors flee, as often happens when a quarterly payer announces a surprise reduction after a 3 month waiting period.  This is an unlikely scenario though, since this is an ETF with diverse holdings and not an individual company.  Additionally, monthly payouts allow the holder to put that cash back to work more quickly, albeit through reinvestments, or income back to the investor directly.  While PFF‘s share price took a hit during the economic collapse (who didn’t), the dividend payouts continued at roughly the same rate.

Preferred Stock ETF Risk

The primary risks as I see them now are a wave of defaults similar to defaulting on loans from online lending companies, which would place preferred payments down on the hierarchy (unlikely given recent recovery and government backstop); but more prominently, interest rate risk – a common bane of high yield investments is a rising interest rate environment. As higher yields become available in safer vehicles like government bonds, CDs (although you have protection with Flex CDs), money markets, etc., and interest rates are perceived to continue upward, cash leaves high yield investments, driving the yields higher but sending the share price lower.  In the case of PFF, as long as the dividend payouts continue at a reasonable rate and you’re not selling, it’s a non-event.  However, if you’re looking to sell PFF in 2011 at a time when rates may be rising, a decline in share price may offset your dividend income.

Top Holdings (preferred shares):

• Barclays
• Citigroup
• Deutsche Bk
• Ford Mtr
• Metlife
• Morgan Stanley
• Natl City Cap T
• Public Storage
• Usb Cap Xi
• Wells Fargo Cap

Disclosure: No position in PFF

Tagged as: Preferred ETF