The 'Preferred' Way to Play Financials

By Matthew Hougan

With the Financial sector trading 80% off its highs, you might be tempted to buy a Financials sector ETF. But there might be a better way to access Financials.

I'll admit: As a contrarian, Financials look pretty attractive. Not only is the sector down huge, but just about everyone has given up on it. People hate Financials; they think all the major banks are doomed; they're tarring the industry with a broad brush. That's the classic case for capitulation, and almost always the point where real money is made.

Jim Wiandt succumbed to that temptation this winter, when the Select Sector SPDRs - Financials (NYSE: XLF) ETF was trading around $12/share. But Jim's case is telling: He subsequently lost 50% of his investment. I'd like to avoid that.

Still, I can't keep my eye off the sector. At some point, there has to be opportunity ... somewhere. What I'm wondering, however, is if a traditional equity ETF is the best way to play it.

The alternative would be to buy a preferred stock ETF, such as the iShares S&P Preferred Stock Index Fund (NYSE: PFF) or the PowerShares Financial Preferred Portfolio (NYSE: PGF). Preferred shares occupy a senior space in the credit ladder to common stocks. They pay a fixed dividend that is only reduced or canceled under extreme circumstances (which admittedly could be now).

PFF is about 80% exposed to the Financials sector, and holds only U.S.-listed securities. PGF is 100% Financials, but holds U.S. as well as international names. PGF is currently paying a 19% SEC yield, compared to 10.6% for PFF, according to PowerShares and iShares, respectively.

There's huge risk to these funds, and their "preferred protection" hasn't been much help over the past year. PGF is trading down 65% over the past 12 months, and PFF is down about 58%. Both are doing better than XLF, which is down 70%, but not by much. The market is clearly pricing in a fair amount of pain for preferred shareholders.

Still, there's reason to be hopeful. The government has been buying preferred shares in banks, so it has an implicit stake in maintaining the value of these preferred securities. In addition, foreign governments are large holders of preferred shares, and the U.S. government has an incentive to protect the investments of our foreign creditors.

I'm not quite settled on the issue, but think it's worth considering. (I'm not the only one: Morningstar has been writing extensively on this recently.)

I think it's likely (although by no means certain) that preferred shares continue to outperform traditional equities if the market stays tough for Financials. And even if the clouds clear, a case could be made.

Let's suppose that the clouds lift a little on Financials: Not enough to clear the runways for strong profit growth, but enough to let the industry limp along for a few years in recovery mode. In that scenario—where survival is clear but success unlikely—preferred shares should do very well.

There's no free lunch in Financials. The risks are huge and the waters are dark. But preferred shares are at least worth thinking about.

Comments

[jcianci:]

yes i agree with PFF as a highly speculative investment if you need exposure to this sector, but you also need to hedge. Like the XLF example mentioned above, you can just as easily lose 50% in PFF. Hedge by selling covered calls. The July 21 calls offer a >10% premium at current price (20.50 as of 2/26 9:45AM). This will reduce your cost 10%, collect another dividend (if not called) and if called, a 10% return in the books. Yes your capital gain upside is limited but in this market mitigating risk should "bear" fruit...

Feb 26 09:47 AM

[Gluteus Max...:]

I've been purchasing preferred etfs for several months and enjoying the ride so far. Getting paid to wait if you can take the upds and downs. Keep in mind the tax implications of PFF, PGX and PGF. Only PGX is 100% QDI (favorable tax treatment) the others don't fully qualify.

Feb 26 11:03 AM

[oldman:]

PGX shows dividends at ordinary income.

Ex-Date Record Date Pay Date $ / Share Ordinary Income Short Term Gains Long Term Gains Return of Capital
2/13/2009 2/18/2009 2/27/2009 0.09448 0.09448 N.A. N.A. N.A.
1/15/2009 1/20/2009 1/30/2009 0.10051 0.10051 N.A. N.A. N.A.
12/15/2008 12/17/2008 12/31/2008 0.11707 0.11707 N.A. N.A. N.A.
11/14/2008 11/18/2008 11/28/2008 0.12500 0.12500 N.A. N.A. N.A.
10/15/2008 10/17/2008 10/31/2008 0.07614 0.07614 N.A. N.A. N.A.
9/15/2008 9/17/2008 9/30/2008 0.10080 0.10080 N.A. N.A. N.A.
8/15/2008 8/19/2008 8/29/2008 0.11874 0.11874 N.A. N.A. N.A.
7/15/2008 7/17/2008 7/31/2008 0.11752 0.11752 N.A. N.A. N.A.
6/13/2008 6/17/2008 6/30/2008 0.11767 0.11767 N.A. N.A. N.A.
5/15/2008 5/19/2008 5/30/2008 0.11778 0.11778 N.A. N.A. N.A.



On Feb 26 11:03 AM Gluteus Maximus wrote:

> I've been purchasing preferred etfs for several months and enjoying
> the ride so far. Getting paid to wait if you can take the upds and
> downs. Keep in mind the tax implications of PFF, PGX and PGF. Only
> PGX is 100% QDI (favorable tax treatment) the others don't fully
> qualify.

Feb 26 11:47 AM

[jeerio:]

having made a few bucks with PFF (5 points as i recall, from 40 to 45), i got back in and out quickly late last summer as things became dicey, took a few percent loss.

it's now 20, and i for one see it will continue much lower even utilizing the risk-reduction technique of selling covered calls, as suggested by one commentor.

the author's suggestion that there is likely to be continued outperformance by PFF vs. the equities is fairly humourous. ok, so most financial equities are down what? 80% ? PFF is only down 55%.?

referring to that as outperformance is the kind of thing that makes my head hurt.

Feb 26 11:59 PM

[MarkTwain:]

I've been buying PGF over the past month. My rationale is as follows:

- governments will not let the components of the WHPS index fail - that doesn't mean they might not punish the preferred but it's unlikely given the need to attract private capital (this is not a French style nationalization for the long-term and screwing the shareholders a la Paulson is no longer seen as smart)

- my quick review of the portfolio (remember to look at the Powershares site for the latest composition as for instance Schwab's summary is way out of date) indicates that only around 17% of the portfolio is at risk of a government intervention (this is a big assumption based on the cushion of common equity value below the preferred)

- this means that you might lose part of the 17% (but with Citigroup you actually should have ended up with more given the deal proposed) but in return you are getting a 20% tax-advantage cash yield (caveat that the yield will decline as the weaker preferreds get washed out)

- the real risk is my mind is a deferral of the preferred dividends even by some of the healthier groups. I judge this as unlikely unless the banks' situations are even worse than feared since it would again making raising private capital problematic. But if it does happen it will clearly impair the pricing although in the longer term dividends will be restored and there will be a recovery in value. I have not investigated whether the larger components have cumulative preferreds in which case you won't lose the dividend, just have it delayed. It's possible also that mergers would occur which would be likely to result in a payment at par.

So for someone who is able to take a 3 year view, I think this looks like a great investment: if I assume buying at 33% of par, holding for 7 years and receiving a 20% yield on purchase price and return of principal, I get a 7 year IRR of 32%. If I assume 33% of par, hold for 7 years, and yield of 10% (whack half of the dividends) and assume I get 70% of par, the IRR is 19%, both of these tax-advantaged. So clearly there is panic built into the pricing of these securities. Or I'm missing something....Armaggedo...

And if my hypothesis is correct, then there should be a major uplift as several factors converge:

- confidence about which banks are healthy is established through the stress tests
- the governments (RBS, Citigroup) continue to protect preferred shareholders
- risk premia decline from the completely manic levels of today and investors focus on the longer term instead of using a 2 year discount period
- there is more transparency on this ETF (as I said I think there is misinformation in what is actually in the ETF as it gets rebalanced every month)

Mar 03 11:57 AM

[MarkTwain:]

Well, PGF is up from 5 and change to nearly 11, so it's time to rotate into the common.

Apr 12 09:39 PM

[MarkTwain:]

Well, PGF is now nearly $14. Did anyone take my advice? If you did at the bottom, you have nearly a triple in about 2 months.

May 09 09:40 PM