The True Risks Behind Preferred Stock ETFs

Investors in search of solid income from their portfolios often select preferred stocks, which combine the features of stocks and bonds, rather than Treasury securities or ETFs based on Treasury bonds. One reason behind the decision to go with preferred stocks is that they generally pay higher dividends. Another advantage of owning preferred shares rather than bonds is that their dividends are taxed as long-term capital gains, rather than income. The interest paid on Treasuries and corporate bonds is taxed as ordinary income. However, investors must be mindful of the IRS rules on qualified dividends, because not all dividends are taxed at the lower rate.

Although preferred stocks can offer some benefits, they also pose some risks. We review those risks here and also take a look at two popular preferred stock ETFs: the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF) and the First Trust Preferred Securities and Income ETF (NYSEARCA: FPE). All information presented here was accurate as of Oct. 5, 2018. 

A big risk of owning preferred stocks is that they are sensitive to interest rates. Because preferred stocks often pay dividends at average fixed rates in the 5% to 6% range, the share price falls as prevailing interest rates increase. As Treasury bond yields approach a preferred stock’s dividend rate, demand for the stock declines, sending its price lower. The safe haven provided by Treasuries can be an advantage over assuming the risks of preferred stock ownership.

Another risk shared by most preferred stocks and bonds is call risk, since most preferred shares allow the issuing company to redeem the shares on demand before they mature. This usually happens when interest rates fall. The issuing company may then redeem those shares for a price specified in the prospectus and reinvest them in what could be a less favorable environment. 

Preferred stocks also present liquidation risks. If a company is liquidated, it must pay all of its creditors first, and then bondholders, before preferred stockholders claim any assets.

Preferred stocks are rated by the same credit agencies that rate bonds. The top three rating agencies are Moody’s, Standard & Poor’s and Fitch Ratings. While preferred stocks can earn a rating of investment grade, many have ratings below BBB and are considered speculative or junk. Some preferred stock ETFs limit their holdings to investment-grade stocks, while others include a significant allocation of speculative stocks. The cautious investor must become familiar with the particular investment strategy and portfolio holdings of the ETF. Industry sectors have their own particular risks as well, as demonstrated by the hardships endured by sectors such as the oil and gas industry.

The iShares U.S. Preferred Stock ETF is the largest preferred stock ETF, with total assets exceeding $15.80 billion. The fund's trailing 12-month dividend yield is 5.57%, and it has an expense ratio of 0.46%.

This ETF tracks the performance of the S&P U.S. Preferred Stock Index. Its 302 portfolio holdings are heavily skewed toward the financial sector, with banking sector securities comprising 34.42% of its weight, diversified financial securities comprising 25.14%, and the insurance sector accounting for 10.16% of the portfolio weight, totaling 69.72% of the fund's holdings. This lack of diversification could alienate a significant number of risk-averse investors beyond those who fear another financial crisis.

Of the major preferred stock ETFs, the First Trust Preferred Securities and Income ETF is the third largest, with 158 holdings and total net assets of more than $3.50 billion. The fund has a trailing 12-month dividend yield of 1.12%. This is an actively managed ETF, and it has an expense ratio of 0.47%.

Only 25.5% of FPE's holdings are investment grade (BBB or higher). Speculative-grade investments, with ratings from BBB- through B-, accounted for 68.66% of the fund’s holdings, and 5.84% were unrated. Risk-averse investors might also be concerned about this fund’s lack of diversification, as it has a heavy allocation toward the financial sector. As of April 19, 2016, the banking sector accounted for 38.92% of the fund's portfolio weight, followed by insurance securities at 18.31% and capital markets at 11.62%. With an additional 5.67% of the fund’s assets invested in consumer finance sector securities, as well as 5.06% in the consumer financial services sector, this ETF had 79.61% of its total assets allocated toward the financial sector.