Preferred stock ETFs were once considered a tiny corner of the alternative income marketplace that had dodged the bullet of credit contraction. High yield mainstays like junk bonds, master limited partnerships, and even REITs have felt the pain of income investors reeling in their risk targets and running for the safety of high quality bonds.
That picture changed dramatically this month as the iShares U.S. Preferred Stock ETF (PFF) fell 5% from high to low and is scrambling to claw its way out of the abyss. This uptick in volatility may come as a surprise to many who had become accustomed to small prices changes in the index over the last several years.
Preferred stocks are somewhat of a hybrid instrument that carry qualities of both equity and debt instruments. Therefore, with interest rates falling, it must be an equity-driven event that is causing this turmoil.
A quick check behind the scenes of PFF reveals that this fund owns a diversified mix of 260+ individual preferred securities. Yet the single largest underlying sector is banks (42%) and diversified financial companies (18.50%). Together these two groups make up over 60% of the total portfolio and will therefore contribute an outsized portion of the fundamental price action.
An overlay of PFF versus the SPDR S&P Bank ETF (KBE) shows that the preferred stock index began a pronounced downside move in tandem with the sharp dive in publicly traded bank stocks (blue line).
PFF had a much more muted percentage drop than KBE. However, it is clear that the stress in banking stocks is also translating to a measure of fear in the underlying preferred market as well.
Another interesting phenomenon with this price action has been the relatively swift and sharper recovery in PFF versus KBE. While banks are barely off their lows, PFF has been able to recover more than half of its corrective move. Only time will tell if this V-bottom formation will hold or if there will be another round of selling that will again test the resolve of income investors.
I have owned PFF for clients in my Strategic Income Portfolio for a number of years and have been pleased with its makeup and performance over that time frame. A fund of this nature provides us with exposure to an alternative asset class with a much lower beta than a traditional dividend equity fund. It has also demonstrated a much stronger comparable income stream than a diversified bond fund.
We view preferred stocks as a tactical opportunity in the context of a diversified income portfolio. This means that they are typically sized smaller than a core holding and may be added or removed as necessary to accommodate the current interest rate or stock market environment.
Moving forward, I will be closely monitoring the price action in this sector to determine if we should scale back our position or continue to hold as this recovery develops further. Either way, our process will entail incremental steps and a thorough evaluation of the income landscape to ensure proper alignment with our conservative mandate.
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