Reasons To Stick With Preferreds And This ETF

With U.S. interest rates hovering around historic lows, the income from many fixed-income investors is dwindling. And with few, if any, sign from the Federal Reserve that interest rates are going to rise anytime soon, investors are increasingly seeking higher-yielding assets within the fixed income universe.

That includes this year's well-documented return to preferred stocks and the corresponding exchange-traded funds. 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.

Of course, sensitivity to rising rates comes by way of a bond's duration; the longer the duration, the more sensitive it is to fluctuations in interest rates.

What Are Preferreds?

A preferred stock is a type of security that offers characteristics of both bonds and equities. The primary source of allure with preferreds is yield, although preferred shareholders are higher on the totem pole in the event of issuer bankruptcy or default than are common equity holders.

The Elkhorn S&P High Quality Preferred ETF (BATS: EPRF) represents a new avenue to an old asset class, and, as it matures, EPRF could prove to be a better preferred mousetrap.

The Elkhorn S&P High Quality Preferred ETF follows the S&P U.S. High Quality Preferred Stock Index, which selects fixed-rate investment grade preferred issues (BBB- or higher) from U.S. listed preferred stocks and maintains an allocation of 75 percent to cumulative preferreds, according to Illinois-based Elkhorn.

Call risk is an issue to consider with preferred strategies, and EPRF might have some advantages on that front as well.

The Appeal Of EPRF

The analysis of the S&P U.S. Preferred Stock Index shows that if all preferreds at increased risk of being called are indeed called over the next three years, preferreds would lose approximately 17bps per year versus high yield. For yield-focused investors, the preferreds call risk appears insignificant, said Elkhorn's Graham Day on the S&P Dow Jones Indexology blog.

EPRF's underlying high-quality index includes investment-grade constituents only, whereas 44 percent of the broader preferred index includes speculative-grade stocks and another 14 percent is not rated. Similar to corporate bonds, preferred stocks are sensitive to changes in interest rates, however, also similar to equity, preferred stocks exhibit more volatility than most fixed income asset classes, according to S&P Dow Jones Indices.

At a time when investors are emphasizing quality, notable is the fact that EPRF is the only preferred ETF going out of its way to do the same.

Within the preferreds space, high quality, investment grade preferreds offer investors access to preferreds while providing unique exposure outside of banks or the UK as well as a defensive tilt to hedge against down markets. In summary, preferreds appear well positioned against high yield bonds for investors looking for a combination of higher yields and lower risks, added Day.

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