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By Abby Woodham

With yield so scarce today, investors are branching out into different asset classes in the search for income. We’ve seen particularly large inflows into high-yield, corporate-bond, and REIT exchange-traded funds, some of which have doubled in size during the past year. Many investors have set upon preferred stock, which is a hybrid security usually issued by highly leveraged companies, such as financial institutions, telecoms, and utilities. Preferred stock has characteristics of both bonds and stocks. Like stocks, preferreds are traded daily on an exchange. Like bonds, they pay fixed income on a regular basis (usually quarterly) and do not benefit from earnings growth of the issuing company. In the capital structure, preferred stock is senior to common stock but junior to corporate bonds, and preferred shareholders have no voting rights.

The largest preferred stock ETF is iShares S&P U.S. Preferred Stock Index (PFF). PFF is about 5 times the size of its nearest competitors and has greater liquidity. This fund’s wide range of preferred stock (almost 300 different issues are included) can be a satellite addition to a diversified income-seeking portfolio, and many have embraced it: PFF grew its assets by more than 2 billion dollars this year. Preferred stock is a good diversifier: It has low correlation to other income-generating asset classes like REITs, master limited partnerships, corporate bonds, Treasury Inflation-Protected Securities, and popular income ETFs like Vanguard Total Bond Market ETF (BND) and SPDR Barclays Capital High Yield Bond (JNK).

Preferred stock is not without its headwinds; in fact, there are many significant risk factors that investors must consider. Heavy exposure to financials, regulation changes, and rising interest rates are foremost on this list. We also believe the asset class is close to fully valued at this time. Preferreds are sensitive to interest rates, but unlike bonds, they are 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 share prices fall. Preferreds also have call options baked in, usually about five years after issuance, but some can be called even before then. Issuers can suspend dividend payments during rough periods, and in the event of bankruptcy, owners will walk away with nothing: For example, investors in preferred shares from Fannie and Freddie lost everything.

The tax treatment of preferred stock can vary; PFF's dividends preserve the tax treatment of the underlying securities' dividends, which has resulted in its investors usually paying qualified rates on about 50% of dividends, ordinary income on the other half, and capital gains on sale of PFF. If the Bush tax cuts are not renewed, qualified dividends will be taxed at marginal income tax rates.

Fundamental View
The lion's share of preferred stock is issued by global financial institutions, and PFF's portfolio reflects this with more than 85% taken up by financials. Banks issue “trust” preferred stock, a particular flavor of the asset, to comply with federal regulations and meet certain capital requirements. Preferred stock is considered Tier 1 capital. Until now, banks have favored preferred stock to raise Tier 1 capital because it is cheaper to issue than equity. However, because of Basel III regulation, banks with assets over $15 billion must begin to phase out preferred stock as Tier 1 capital by the end of the year, with the transition period fully ending in 2015. From the bank issuers' perspective, preferreds will lose their appeal as soon as banks cannot use them as Tier 1 capital. Banks will aim to call their preferreds as soon as possible, which could be sooner than expected: Preferred stock over five years old can be called (usually the minimum requirement for a call option to become active), but younger issuance is also at risk. Provisions allow for an early call in the event of a "capital treatment event," which could legally apply to this regulation change. Some issuers have already acted on this clause, redeeming shares before the expected call date. As of April, PFF owned about 40% trust preferreds, all of which face early call risk. If shares get called while above par, which happened to several different preferreds last month, investors could be burned. Slightly less than 2% of PFF was called in the past month, which is minor for now but might be symptomatic of larger redemptions in the future as more banks call their preferreds in response to regulations.

PFF is currently yielding almost 6%, which beats 10-year Treasuries by more than 4%. This spread is difficult to top by any other asset class. Since the financial crisis, the spread between Treasuries and preferred stock has bounced between 4% and 6%, so today's yield is on the lower end, suggesting preferreds are close to fully valued. Until the mandated changes in banks' capital structure are completed, or investors start finding income elsewhere and preferreds get bid down, it is unlikely the yield will move very far in either direction from 6%. Without much room for appreciation, investors will have to be satisfied with yield alone. Thankfully, preferred stock has plenty of it to sweeten the pot.

Portfolio Construction
PFF tracks the S&P U.S. Preferred Stock Index. The index includes preferred stocks that meet certain liquidity requirements and have a market cap of more than $100 million. Single issuers cannot make up more than 10% of the index, and rebalancing occurs quarterly. Constituents are omitted or removed when their maturity or forced conversion is slated to occur in 12 months or less. The index does not restrict constituents based on credit quality, so PFF does include non-investment-grade issuance (almost 35%), with investment-grade (44.78%) and unrated (20.63%) making up the remainder. More than 75% of PFF is U.S. issuance, with the United Kingdom and the Netherlands together making up about a fifth. About 85% of the fund is financials, with small weightings in utilities, capital goods, automobiles, and telecommunications.

Fees
The fund charges a 0.48% expense ratio, which is the lowest of its peers and in line with other high-yield bond funds. The fund is allowed to engage in securities lending, and 65% of the resulting income is returned to the fund. Parent BlackRock reimburses the fund for any losses arising from securities lending.

Alternatives
PowerShares Financial Preferred (PGF) has some favorable rules that other preferred stock funds lack: Trust preferreds are banned, and only stocks paying out qualified dividends are allowed. PGF will have fewer problems with changing bank regulations. This ETF has major international exposure because U.S.-domiciled issuance makes up only about half of the portfolio. Investors will need to be very comfortable indeed with investing in European banks.

PowerShares Preferred (PGX) is very similar to PFF: equivalent fees, portfolio quality, country exposure, and financials weighting. The biggest difference between the two is PFF's larger number of holdings.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: We'd 'Prefer' To Look Elsewhere For Yield