With interest rates frozen at near-zero levels for the next two years, investors have been scrambling to find sources of income for their portfolios. As such, dividend investing has become increasingly popular in the past few years, as investors have been quick to adopt the benefits offered by securities that pay out a steady cash distribution. Though some go for bonds and others may hone in on a particular equity sector, preferred shares represent one of the most enticing plays in today’s environment.
Preferred stock represents a unique class of ownership that has a higher claim on the assets and cash flow than common stock, meaning preferred shareholders will generally receive a dividend that must be paid out before dividends to common stockholders. The higher priority on the pecking order for dividends makes preferreds especially enticing, not to mention that their yields are typically higher than those of common shares. But be warned that the high yields offered by these securities are accompanied by a number of risks.
What to Watch For
Eventually, interest rates will have to rise, and that will have an adverse impact on these securities as they behave like bonds in that rising interest rates drive down prices. Rates are effectively frozen through 2014 and may continue at low levels for some time after that, but be ready to pull the trigger if an inflationary environment presents itself. Another risk to watch for is a “call” of your preferred shares, an event in which the company redeems the shares, which typically pushes market prices down as many try to sell-out prior to the redemption. "In most cases, a company will call a preferred stock if it saves them money to do so," writes Doug K. Le Du.
Below, we outline several ETFs to take advantage of preferred shares as they are currently some of the best-yielding options available.
- S&P US Preferred Stock Fund (PFF): The most popular preferred shares ETF, PFF is home to over $8 billion in assets and exchanges hands over 1.6 million times each day. It should be noted that of the fund’s 250-plus holdings, the largest allocations are given to financial firms like Citigroup (C) and ING (ING). PFF is currently yielding a handsome 6.45% and is up almost 30% in the last three years.
- Preferred Portfolio (PGX): This fund is designed to replicate the total return of a diversified group of investment-grade preferred securities, where PFF incorporates a fair amount of holdings that fall below investment grade. With the focus on only investment-grade shares comes a more shallow portfolio, however, as the top 10 holdings account for over 36% of the fund. PGX has a 30 day SEC yield of nearly 7% and has jumped about 5% on the year.
- S&P International Preferred Stock Index Fund (IPFF): IPFF is a relatively young product that invests in preferred shares listed outside the U.S. For those who are bearish on our local economy, this fund presents a great alternative with exposure to countries like Canada, the U.K. and Sweden. Be mindful, however, of the fact that IPFF is made up of nearly 75% financials, which could scare some away. This ETF is currently yielding 3.3%.
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Disclosure: No positions at time of writing.