Investors who are looking for an alternative to dividend exchange traded funds have been looking into preferred stocks. Fears of the fiscal cliff have prompted investors to bail out on some dividend plays, such as telecom and utilities, due to the anticipated higher taxation rate.
"The 'a-ha' moment as it pertains to the fiscal cliff comes from realizing that a company that is paying a preferred dividend had better make that payment or risk damage to its credit rating. A company that is consistently in arrears on preferred dividend payments risks a lower credit rating and that leads to higher borrowing costs," Benzinga reports.
The threat of companies forgoing increasing dividend rates, mixed with the looming higher taxation rate, has some investors searching elsewhere for yield. Preferred shares are a frequent stop for investors who are looking for higher yields with equities.
Preferred shares are hybrid stocks that are issued by highly leveraged companies. They have traits that resemble both equities and bonds. "Like a stock, preferreds are traded daily on an exchange. Like a bond, they pay fixed income on a regular basis and do not benefit from earnings growth of the issuing company. Preferred stock is very susceptible to interest rates, but unlike bonds, it is at risk in both directions. When rates fall (presently an unlikely event), issuers often call shares to reissue at lower, more favorable rates. When rates go up, preferred stock suffers," John Gabriel wrote for Morningstar.
Preferred stock ETFs are taxed as common stock dividends. Companies that issue preferred shares must have healthy balance sheets and strength in the underlying business. It is up to investors to double check that the companies represented in an ETF index are sound. Likewise, an ETF can help mitigate the risk of an unhealthy company since the portfolio contains many companies.
The iShares S&P U.S. Preferred Stock Index Fund (PFF) yields 5.71% and has $10.5 billion in assets. The ETF has suffered as the fiscal cliff fear has become stronger, due to the high exposure to financial and banking companies. The sell-off has also given the fund more allure to investors searching for beaten-down investments.
- Global X Canada Preferred ETF (CNPF) yields 3.68%
- PowerShares Preferred Portfolio (PGX) yields 6.52%
- Market Vectors Preferred Securities ex Financials ETF (PFXF) yields 4.31%
Tisha Guerrero contributed to this article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.