Preferred Stock ETFs: An Alternative Source Of Yield

Includes: FPE, PFF, PGF, PGX
by: Tom Lydon

Preferred stock exchange traded funds are known for their income-boosting characteristics but they offer a portfolio other benefits. The low correlation that a preferred stock has to other asset classes is another huge plus.

A preferred stock is essentially a blended security made up of leveraged companies. The stock has bond characteristics in that they pay a fixed income regularly and do not prosper from the earnings growth of the subject company. The preferred stock trades on an exchange just like any other security. Preferred stock is senior to common stock but junior to corporate bonds, and shareholders have no voting rights, John Gabriel wrote for Morningstar.

"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," he notes.

Most preferred stocks are issued from banking and financial companies, reports Zacks.

The PowerShares Preferred Stock ETF (NYSEARCA:PGX) presents a low correlation to other income boosting sectors such as REITs, MLPs, corporate bonds and TIPS. However, PGX has about 90% of the portfolio invested in financials, as most preferred shares focus on this sector. PGX yields about 6.5%, a decent payout compared to Treasuries. PGX costs 0.50%. The iShares S&P U.S. Preferred Stock Index (NYSEARCA:PFF) costs 0.48% and offers investors the same amount of exposure to financials. PFF is the largest preferred stock ETF.

The PowerShares Financial Preferred Portfolio (NYSEARCA:PGF) is a pure play on the financial sector. PGF has a large allocation to international banks, which can be a problem for some investors. However, trust preferreds are banned, and only stocks paying out qualified dividends are allowed. PGF will have fewer problems with changing bank regulations, and its tax treatment will likely beat its competitors.

The latest launch from First Trust is the First Trust Preferred Securities and Income ETF (NYSEARCA:FPE), which is the first actively managed strategy in this area of the market. Cinthia Murphy of Index Universe explains that the stocks in the index behave similarly to corporate bonds because of their steady distributions, but with equity -like features. The fund has a focus on finding the best relative values in the market. FPE costs 0.85% for the active management, and yields anywhere from 5.5% to 6%.

"Preferred securities have historically proven to be a more reliable source of income than common stocks as they are senior in the capital structure, have produced a more stable stream of income and have been less volatile," First Trust said in paperwork it published on its website.

iShares S&P U.S. Preferred Stock Index

Tisha Guerrero contributed to this article.

Full disclosure: Tom Lydon's clients own PGF.

Disclosure: I am long PGF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.