Preferred Stock ETFs Provide Potential Fed Clues

Income investors embraced preferred stocks, in large part, because of high yields, but as the spike in Treasury yields earlier this year and in 2013 taught investors, high-yielding assets are vulnerable to rising rates.

Preferred stocks are often viewed as hybrid securities, displaying both bond- and equity-like traits, and reside higher on the totem pole than do common stocks in terms of investor claims in the event of issuer default. As is the case with bonds, preferreds are sold at par value, or offer a fixed or floating rate of income, so prices fluctuate with interest rates, wrote William Scapell, director of fixed income and preferred securities portfolio manager at Cohen & Steers, for InvestmentNews.

ETFs To Play

Legacy preferred ETFs, including the iShares U.S. Preferred Stock ETF (NYSE:PFF) and the PowerShares Preferred Portfolio (NYSE:PGX), sport sizable enough yields that these funds qualify as high-yield instruments, in turn making these ETFs and others like them vulnerable to higher interest rates. PFF and PGX carry 30-day SEC yields of 5.35 percent and 5.94 percent, respectively.

That is to say if investors were betting that the Federal Reserve will announce higher interest rates following the conclusion of its two-day meeting Thursday, preferred stocks and ETFs would not be the place investors would be running to. However, that is what they are doing.

Since the start of the third quarter, PFF has added just over $350 million in new assets. PGX has seen $49.6 million of inflows over the past 90 days, placing it thirteenth among all PowerShares ETFs, according to issuer data.

The fourth-place ETF on that PowerShares list is the PowerShares Variable Rate Preferred Portfolio Fund (NYSE:VRP), which makes sense because VRP is the one preferred ETF designed specifically with higher interest rates in mind.

Debt securities with floating or variable rates may help protect investors from a rising rate environment. Even if maturities extend beyond a call date, interest rate risk can be much lower and is limited to the time until the next rate reset, according to anew research note from PowerShares.

VRP, which has a 30-day SEC yield of 5.16 percent, has added $120.4 million in new asset over the past three months. With that yield, VRP is certainly in the high-yield conversation, so its recent burst of asset-gathering proficiency cements the notion that investors are embracing preferred ETFs at a time when it would appear risky to do so.

Investors are also embracing actively managed preferred ETFs. In the current quarter, the First Trust Preferred Securities and Income ETF (NYSE:FPE) has taken in $86.4 million of its $349.6 million in assets under management.