The iShares U.S. Preferred Stock ETF (NYSEARCA:PFF) has enjoyed rock star status among income investors since the financial crisis. A lot of people are buying this fund without really realizing what stands behind this fabulous past performer with a nice yield of 5.76%, nicely diversified among almost everything that is out there in the preferred stock universe.
I want to start with one of the main principles in fixed-income investing, which is Yield to Worst - the lowest potential yield that can be received on a bond without the issuer actually defaulting. One of the worst things you want as an investor in fixed income is to pay a price higher than the call price on an issue that is callable. There is a chance that the callable stock or bond may not be called, but it is not worth the risk. A situation in which it is worth buying a product like this is if you have insider information that the company is not going to call it (trading on insider information is not legal anyway). You can also buy a callable issue if it is so special to the capital structure of the company that you are sure it is not being redeemed.
PFF and its history with callable stocks
I have been monitoring the fund's performance every day for the last 7 years. This includes the fact that I know what stocks the fund is buying or selling every single day (3 days after the trade). What I always found strange is that PFF management has no problem buying callable stocks above their call price, and is never actively selling such stocks when they reach their call price. Some will say that the fund's investment strategy is to follow the underlying index, but this is not exactly the case - neither in practice nor in the prospectus:
"Management Risk. The Fund may not fully replicate the Underlying Index and may hold securities not included in the Underlying Index. As a result, the Fund is subject to the risk that BFA's investment strategy, the implementation of which is subject to a number of constraints, may not produce the intended results"
The first stocks that come to my mind are Ford Motor Company's (NYSE:F) preferred stocks, F.PA and F.PS. They got redeemed several years ago, but what was really strange is that at the time F started redeeming all of its exchange-traded debt, third-party securities, and preferred stock, F.PA and F.PS were also callable. F.PS was one of the biggest holdings of the fund at the time, and it just continued buying it above the call price. F.PA was callable at $25, and the stock traded as high as $27.50. That is just one of the many examples I remember, but probably the fact that I was shorting those stocks over and over again at the time makes it shine brighter for me. PFF, at the time, was a "small bunny" compared to the "elephant" it is today with its almost $14.5 billion of assets. The methodology of the US preferred stock index has changed drastically for the last 7 years, allowing PFF to become more and more diversified. I am not going to go deep in the methodology changes, but after 8 years of management and all the changes being made and all the experience gathered, one would expect different behavior, and to be honest, the inefficiencies are now less than they used to be in the preferred stock market, but let's look at the current PFF.
(Source: Author's calculations based on PFF data)
When looking at this chart, the first thing that comes to my mind is: "A leopard can't change its spots". I had to make two pictures because one screen is not enough for all the callable issues. Nearly 30% of the fund's holdings trade with negative yield to worst. Some of them, like HSBC Holdings plc (NYSE:HSBC) 8.125% Exchangeable Perpetual Subordinated Capital Securities (HSEA), for example, have traded like this for quite a long time, and no one knows whether they are going to get redeemed, but the risk stays. This time, it is not PFF that is to blame - it is just the fact that the stocks became callable (PFF cannot sell those stocks easily even if it wants to). Those stocks are one of the fund's greatest winners since the financial crisis, and they cannot just be sold, being part of the underlying index and considering the large amount the fund possesses. But for every buyer of the fund this should be a red light, because by constructing your own portfolio of preferred stocks, you can just exclude callable stocks. The current and nominal yield on most of those callable stocks is way higher than the yield on most recent issues with similar rating, which makes them even bigger candidates to be redeemed. The way those stocks trade is what I call static - it is not worth buying them, and it is not worth shorting them. Their credit risk, of course, is very low (because very soon they will be redeemed, or at least someone will start arbitrating them bellow a certain price), and they add stability to the fund's NAV because they are virtually like cash on hand, but they are definitely not what an income investor with 5-year horizon would want to buy. Currently, PFF receives a lot of cash from redemptions (Bank of America (NYSE:BAC) recently called a large part of preferreds) of its holdings, and for it to increase its duration and to improve its yield to worst, only time will help. What is positive is that the fund is less risky in terms of interest rate risk, because an issue that has an 8% nominal yield would be worth redeeming even if interest rates go a little higher. Once again, 30% of the fund's holdings - more than USD 4.7 billion - are callable.
The negative yield to worst does not mean PFF will lose a lot of money (on average, redemption PFF loses not more than 1% of market value) by redemptions, it just means that 30% of the NAV is not really working for you. To prove those words is the fact that PFF has always underperformed its benchmark, even though management has more freedom than most of the passive strategy ETFs:
(Source: PFF home page)
Another thing I have noticed through the years is that PFF is a basket buyer, which means that in its day to day activities, the fund would just buy, for example, 0.30% of all its holdings rather than buy the stocks from one company with the better yield - which, of course, is not really significant, but if you are managing your own money, you would not do that.
Even though PFF is a passive strategy ETF, management can save some money to the fund holders by not buying callable stocks above their call price. The current holdings of the fund contain old callable issues that bring very low risk, but do not bring any real yield rather than return of capital. The diversification is somewhat less than it looks at first sight, because holding different preferred stocks of the same issuer with the same characteristics is basically the same as holding just one of them. I believe that by just eliminating the callable issues plus the issues from one company that are basically the same, an investor can construct a "better PFF" for himself just by a "delete-copy-paste" type of buying without any exhausting research.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.