A Must Own 8.5% Yield For Retirees: PFFA

Summary

• Interest rates are near all-time lows.
• Even though they are likely to rise, yields will remain low relative to historical levels.
• Fixed income investors like retirees are going to need higher yields to generate income at lower price volatility.
• Where can you find fixed income investments that have high yields? Preferred equities.
• We look at the best ETF for preferred shares.
• Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Learn More »

Co-produced with Beyond Saving

Why Recommend Buying Preferred Shares Now?

For income investors, the preferred stock space is one of the most defensive and conservative ways to get exposure to high-yield stocks. Most of preferred investments will have a "par" value, which is the amount the company owes to the investor to redeem the shares. The most common is $25, although it can be any amount the company wishes to assign. There will be a "call date" – the date after which the company has the right, but not the obligation, to redeem the shares. When the company calls the shares, they will have to pay the par value (usually $25), plus any accrued and unpaid dividends. At times, preferred shares may fall in price when the entire market pulls back. However, most carry much less volatility and recover quickly compared to the common equity. This is the perfect combination for those looking for safer income without the drawback of common stock's large swings.

Preferred Stocks in a Low Interest Rate Environment

If you follow me, you know that I have been singing the praises of preferred equity from the rooftops. Low-interest rates are here to stay for the foreseeable future. Even as they "rise", it will likely be to levels that are much lower than we have seen through most of our lifetimes.

This puts retirees in a precarious position. Fixed income is a crucial component to an income portfolio. After all, the entire point of having an income portfolio is to have relatively stable and predictable income. Historically, retirees have relied on investment-grade bonds and US Treasuries to fill their fixed income portfolio. Today, yields on such investments are incredibly low with quality companies issuing bonds with coupons at 2% or less. One company we follow, W.P. Carey (WPC) retired 2% debt early with new 0.95% Notes!

I don't know about you, but if my money is only earning 0.95%, I'd rather spend it. So where do you go to get a higher yield, but still have the benefits of fixed income and without going too far out on a limb taking on too much risk? Preferred equity is one of the best options.

Today, we look at one of the best funds for quickly gaining a diverse exposure to preferred equity: Virtus InfraCap U.S. Preferred Stock ETF (NYSEARCA:PFFA) provides a yield of 8.5%.

Unlike the vast majority of ETFs which passively track indexes, PFFA is a managed ETF. This means that the managers are making decisions day to day on which stocks to buy and which to sell. This is very important because in this low-yield environment, many preferred shares are trading above par value with very low or even negative "yield-to-call". Meaning that if the company calls the shares, the investor will have a very low return, or even a loss.

Avoiding such preferred shares (or preferred with a very low yield-to-call) is common sense, yet most ETFs that simply follow an index do not exercise any sense at all – they simply buy or sell what the formula (or the underlying index) tells them to.

PFFA uses 20% to 30% leverage to boost income. Due to their opportunistic approach, this ETF currently yields 8.5%. PFFA is currently outearning its dividend and just raised it in January to $0.16/month. PFFA has a sustainable high yield that is based upon dividend income, and potential for capital appreciation as their holdings return to par value or even higher. PFFA's holdings look an awful lot like the HDO preferred portfolio – this makes it a great option for those looking to quickly add exposure to preferred shares.

Holdings

PFFA has more than 150 holdings, though since the world of preferred shares is relatively small, they do have larger concentrations in some.

Source: PFFA

Their largest holding is American Finance Trust 7.5% Preferred A (AFINP), a preferred we have written about several times in the past. AFIN is a triple-net diversified REIT that has a very high quality portfolio. We have been fans of AFINP since it IPO'd.

We are also happy to see several convertible preferred shares. RLJ Lodging Trust, Series A Cumulative Preferred (RLJ.PA) and EPR Properties, 9.00% Series E Cumulative Convertible Preferred Shares (EPR.PE) are both "convertible" meaning that the shares cannot be called. Instead, they are convertible into common shares, only if the common shares go up substantially in price. As a result, these picks have upside well beyond $25 par value. Both companies were impacted by COVID, but both companies also had very strong balance sheets and lots of cash on hand allowing them to get through the crisis without suspending the preferred dividends.

We have said it before, if we were to create an HDO preferred ETF – it would look a lot like PFFA. Among PFFA's holdings (Excel download), there are several other holdings that we are very bullish on. The listing also includes a few baby bonds (even though they're listed as preferred shares).

The Benefit of Being Managed

Let's take a look at the benefit of being managed. Most ETFs pick a benchmark and follow it. PFFA's benchmark would be the S&P U.S. Preferred Stock Index. Yet when Taubman (TCO) was being acquired by Simon Property Group (SPG), PFFA went overweight on TCO compared to the benchmark. So when the deal finally closed, PFFA profited when the preferred were called.

PFFA is overweight real estate at 32.9% compared to 7.56% for the benchmark. We love REIT preferred shares because REITs are required to distribute a substantial portion of their taxable income as dividends. REITs have proven to be incredibly resilient over the years, and REIT preferred are a great place to get above average yields, without taking an above average risk.

So what is PFFA currently avoiding? The financial sector - mostly bank preferred shares. PFFA is 5.45% invested in financials, compared to 44.22% for the benchmark being followed by most ETFs. Most of the preferred shares in this sector are trading above par value and have a low "yield-to-call". The benchmark doesn't care, it will buy regardless of whether the YTC is high, low or even negative! PFFA's management team makes sure that investments not only have a good current dividend, but that there is upside in the future.

Expenses

PFFA's fee ratio is higher than typical for an ETF at 2.0%. This expense ratio is made up of two parts.

First, the management expense is at 0.8% of net assets. This is higher than usual for an ETF, but this is due to the active management discussed above. Those decisions we discussed above? Well you are paying for the people who make them and the time and effort that goes into researching.

At 0.8%, the management fee is well below what we typically see with actively managed CEFs, which usually charge anywhere between 1.2% and 1.4%.

The second part is paying for the leverage that PFFA uses. PFFA leverages up at 20-30% of gross assets. Leverage increases the impact of prices going up or down. In a bull market it improves returns, in a bear market it can accelerate your losses. We never recommend using leverage on your personal portfolio, but we recognize that using leverage can greatly enhance returns. In the case of PFFA, because preferred stocks carry a lower price volatility, using leverage is not much of an added risk.

So how do you gain the benefits of leverage, while mitigating the risk to your personal finances and the rest of your portfolio? Let the fund carry the risk for you. The 1.2% of gross assets that PFFA pays in interest is probably a fraction of what you would pay if you leveraged your portfolio 20%, you get the benefit when NAV rises, and most importantly, the leverage isn't in your brokerage account.

Note that the expense fees are not subtracted from your dividend – those expenses are paid before the dividend is distributed. Therefore investors get the full yield of 8.5%.

Low Interest Rates - The New Normal

For income investors, the preferred stock space is one of the most defensive and conservative ways to get yield with lower price volatility. In today's low interest rate environment, quality preferred stocks can compete with other fixed income investments, such as Treasuries and corporate bonds which effectively provide negative returns if you factor in inflation.

A traumatic event like COVID often has a long tail. Investors run to the safety of treasuries and frequently overestimate the risk of other investments. So today we have a situation where many preferred shares are still trading below par value, even though they are not materially higher risk than they were last February and even though Treasury rates are dramatically lower.

The only real way for that to heal is time, and as time goes on, we will see preferred shares recover to par, and those with call dates far enough out will trade above par. This will be a driving force for PFFA's NAV throughout the year.

In the meantime, you can enjoy collecting monthly dividends.

Source: PFFA

Conclusion

The "Hunt for Yield" continues as incredibly low yielding Treasuries and corporate bonds are driving more investors to seek out higher income. Preferred shares are an obvious alternative, and through all the disruption in 2020, preferred shares in general held up extremely well, and saw a huge recovery.

The bottom line is that many preferred stocks still trade at a discount to par value. Buying these discounted preferred shares is likely to be one of the strongest trades of the year in terms of risk-adjusted return. For retirees who require a predictable fixed income, but do not want the risk of common equities, having a significant allocation to preferred shares can provide the income stability they seek. They also come with an added advantage that they carry much lower volatility than common stocks.

The more conservative an investor you are, the higher allocation we suggest to fixed income securities. We are currently recommending to our members a 45% allocation to fixed income, including "preferred stocks', baby bonds, bonds, and fixed income CEFs. In addition to ETFs like PFFA, our model "preferred stock portfolio" includes over 50 individual preferred stocks with an average yield of 8.1% for those who wish to further diversify. These securities should create the bedrock foundation of your portfolio, like the concrete slab for the foundation of a house.

PFFA, with a yield of 8.5%, deserves a place in any fixed income portfolio, especially conservative investors and retirees. The monthly-pay feature is a big plus for those looking for a regular paycheck.

Analyst’s Disclosure: I am/we are long PFFA. 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.

Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities. Any recommendation posted in this article is not indefinite. We closely monitor all of our positions. We issue Buy and Sell alerts on our recommendations, which are exclusive to our members.