Hunting High Yield? Watch the Correction in Preferred ETFs

by David Fabian | August 16, 2013 9:40 am

Preferred stocks have always been an interesting animal. These income beasts are known for being a hybrid between a stock and a bond that pay phenomenal dividends to shareholders. During the past several years, these dividend machines have been pumping out annual yields anywhere between 5% to 6% with low volatility and excellent capital appreciation.

However, the latest bump in the road for preferred stocks has been the vertical ascent of interest rates that began in May of this year. The prices of preferred stocks typically fluctuate with interest rates (similar to bond prices), but they also can be subject to equity-like price characteristics as well.

The leap in the 10-Year Treasury yield from a low of 1.65% to a high of 2.78% represents an increase of more than 68% in just four short months. This has resulted in nearly every preferred stock ETF on my watch list getting pummeled and most are sitting at or near their 52-week lows. The following are the most popular preferred stock ETFs and the percentage off their highs:

Click to Enlarge
The best of the bunch is clearly PFF, which is the largest preferred stock ETF[6] by assets. The fund holds a whopping $10 billion in assets spread among 323 holdings. The overwhelming majority of the sector allocation in PFF is focused in the financial arena, with real estate and utilities making up a smaller subset. The current 30-day SEC yield is 5.66%, and the expense ratio is 0.47%, or $47 of every $10,000 invested.

In early May, I warned that preferred stocks were looking overvalued[7], and since that time they fallen out of bed. As you can see on the chart above, PFF is sitting well below its 50- and 200-day moving averages and appears to be in a persistent downtrend. In fact, it is dangerously approaching its 52-week lows, which would represent the largest pullback we have seen in this space since the 2008 financial crisis.

So where are these investors going for yield?

Income investors have been fleeing securities that have a high correlation to interest rates (like preferred stocks) and seeking lower-duration, lower-credit-quality holdings instead. ETFs such as the PowerShares Senior Loan Portfolio (BKLN[8]), PIMCO 0-5 Year High Yield ETF (HYS[9]) and the Vanguard Short Term Bond ETF (BSV[10]) have all seen strong inflows[11] this year. Each of these holdings offers improved insulation from the effects of rising interest rates, as well as a healthy monthly yield.

In addition, many investors are so worried about the effects of interest rates on their portfolio that they are simply liquidating their holdings and waiting in the safety of cash for a new buying opportunity.

How to Play Preferred Stocks Today

The No. 1 headwind for preferred stocks today is climbing interest rates. They are essentially behaving the same as bonds in response to QE tapering and economic uncertainty. The benefit of the selloff in preferred-stock ETFs is that they have come down to valuations that we haven’t seen in almost a year. In addition, as they fall, the yield on these ETFs will continue to rise because the coupon of the underlying assets is fixed.

If you are looking for an entry point to start adding this asset class to your portfolio, wait until we start to see some stabilization in interest rates before making an allocation. I am definitely recommending caution at this time because of the potential for a more widespread pullback in the stock market.

I would start by averaging into small positions ito increase your exposure over time and take advantage of lower prices if they continue heading south.

In addition, it is always important to have a stop-loss or sell discipline[12] on any new positions that you establish to guard against further downside.

David Fabian is Managing Partner and Chief Operations Officer of Fabian Capital Management. Learn More: 3 Tenets of Sound Risk Management[13]

  1. PFF:
  2. PGX:
  3. PFXF:
  4. FPE:
  5. IPFF:
  6. largest preferred stock ETF:
  7. preferred stocks were looking overvalued:
  8. BKLN:
  9. HYS:
  10. BSV:
  11. strong inflows:
  12. stop-loss or sell discipline:
  13. 3 Tenets of Sound Risk Management:

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