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Early in August, during the sell off in global markets following the U.S. rating downgrade, preferred shares got hit pretty hard. This volatility seemed unexpected by some investors as they assumed that preferreds were just a capital structure play - claims on preferred equity are between debt and common equity, so investors often expect the risk/return profile of preferreds to line up somewhere between common equity and high yield (as the lowest claim debt). However, there are significant differences within broad indices, from both a sector and issuer exposure, that contribute to large performance differences.
Consider this: The S&P U.S. Preferred Stock Index is heavily weighted in financials (+80%), while the exposure to financials in the S&P 500 is under 15%. In addition, banks issuing preferred securities tend to be investment grade and do not issue much high yield debt (financials exposure in the BarCap High Yield Index is 11%). Given these differences in exposure, investors should not expect the iShares S&P U.S. Preferred Stock Index Fund (NYSEARCA:PFF) to perform similarly to either high yield bonds or broad equity indexes.
Although markets have recovered some of their recent losses, I found myself looking deeper into what has been driving the price of PFF. Comparing the market price of the fund holdings to their par values provided a clue – many of the securities were trading at discounts to par, some significantly so. This was in contrast to even very recently when the fund was at an aggregate premium to par, which got me thinking: does this provide an opportunity for investors as it did in 2009?
Recall in early 2009 when there was discussion of all of the U.S. banks being nationalized. Investors were scared, and due to the ambiguity of how preferreds investors would be treated should a nationalization occur, the securities began trading at a discount to par - a BIG discount - 49%.
So here we are today. The markets are like a wild roller coaster day after day and the performance of PFF reflects similar (but not exact) concerns of increased risk in the global financial sector. Compare the following fluctuations in premiums and discounts for the underlying securities in PFF:
Weighted Avg. Premium/ (Discount) to Par
Current (8/18/11)
Recent (7/26/11)
Extreme (2/25/09)
(5.2%)
0.5%
(49%)
To dig deeper into the sources of the current discounts, we grouped the securities in PFF by different characteristics and looked at their weighted contribution to the overall fund’s discount. The group we found with the largest discount is fixed rate securities, which account for about 85% of the fund and have a weighted discount to par of 3.6%. Grouping a different way, the total weighted discount attributable to European financials in the fund is 2.5% (see table below). A couple of RBS securities skew this higher as they have deferred their dividend payments and are trading at deep discounts to par - taking this into account and excluding RBS, the discount from European financials is 1.8%. Finally, looking only at the Trust Preferred Securities (TruPS), which may be called at par over the next few years due to regulatory changes, the weighted average discount of TruPS is just over 2%1.
Given that European financials have dominated the news lately, I dug in deeper on the discounts to par for securities associated with individual European issuers:
Issuer
Weight In PFF
# of Securities
Weighted Discount to Par (bps)
HSBC (UK & US)
5.19%
6
2
ING
4.27%
7
71
Barclays
4.20%
4
30
Deutsche
4.19%
6
33
Aegon
1.84%
5
27
RBS*
1.05%
2
59
Others
2.77%
8
13
Total European Issuers
23.51%
38
236
*As noted above, the RBS issues have deferred dividend payments
While the securities of these European issuers represent less than a quarter of the portfolio, they are contributing nearly half of the discount to par.
So I was left pondering these “what ifs” ...
If the risks to the global banking system are overblown, PFF could provide the opportunity for both price appreciation (if preferred equities move toward par) and additional income.
If regulatory landscape changes and TruPS are called industry-wide, the weighted discount to par of over 2% could be attractive.
Or if things for the global economy just get worse from here ... well then now is not the time to jump in. But these discounts are probably worth watching as they might get larger and present opportunities down the road.
Notes:
1. These discounts are not mutually exclusive. For example, the discount in a fixed rate TruPS issues by a European financial company would be counted in all three groups.
Sources: BlackRock, Barclays Capital. All data as of 8/18/11 unless noted. Holdings are subject to change. Past performance does not guarantee future results.
Solomon Stewart contributed to this blog.

Carefully consider the iShares Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses, which may be obtained by calling 1-800-iShares (1-800-474-2737), or by clicking the Prospectuses link. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal.
In addition to the normal risks associated with investing, narrowly-focused investments typically exhibit higher volatility. A preferred stock fund may have lower returns than a common stock fund. Preferred stocks are not necessarily correlated with securities markets. Similar to bonds and bond funds, the Fund is subject to interest rate risk; as interest rates rise, the value of the preferred stocks held by the Fund are likely to decline. Removal of stocks from the index due to maturity, redemption, call features or conversion may cause a decrease in the yield of the Index and the Fund. Unlike debt securities, preferred stocks pay dividends at the discretion of the issuer's board of directors, which is not obligated to declare dividends.
The iShares Funds (“Funds”) are distributed by SEI Investments Distribution Co. (“SEI”). BlackRock Fund Advisors (“BFA”) serves as the investment advisor to the Funds. The iShares Blog contributors are affiliated with BlackRock Fund Distribution Company (“BFDC”), which assists in the marketing of the Funds. BFA and BFDC are affiliates of BlackRock Institutional Trust Company, N.A. (“BlackRock”), none of which is affiliated with SEI.
The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications or other transactions costs, which may significantly affect the economic consequences of a given strategy.
This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.
iShares Funds are not sponsored, endorsed, issued, sold or promoted by Standard & Poor's, nor does this company make any representation regarding the advisability of investing in iShares Funds. Neither SEI, nor BlackRock, nor any of their affiliates, are affiliated with Standard & Poor’s.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: Widening Discounts In Preferred Stocks: An Opportunity To Buy PFF?