Why This Could Be The Preferred ETF Of The Future

Preferred stocks and the relevant exchange-traded funds are once again a popular destination for income investors thanks in large part to the Federal Reserve continually holding off on raising interest rates to this point in the year.

High Quality Preferred Joins BATS

Relative to other corners of the fixed income ETF landscape, the preferred space is sparsely populated, indicating there is room for innovation and competition. Some of that new competition and innovation arrived last month with the debut of the Elkhorn S&P High Quality Preferred ETF (BATS: EPRF). What makes EPRF unique is its underlying index, which possesses an emphasis on quality not found with traditional preferred equity benchmarks.

Related Link: Fed Indulges This Preferred ETF

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.

High Yield And Preferreds

Like other high-yielding asset classes, preferred stocks and the corresponding ETFs are viewed as negatively correlated to hawkish changes in U.S. borrowing costs. Income investors embraced preferred stocks, in large part, because of high yields, but as the spike in Treasury yields last year and in 2013 taught investors, high-yielding assets are vulnerable to rising rates.

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.

As has been noted in this space, preferred stocks have perks. Preferred stocks and ETFs have another advantage: Even if the issuer cuts or suspends the dividend on its common stock, it essentially must continuing pay preferred dividends.

Unlike common stock, most preferred dividends are cumulative, meaning dividend payments accrue even if not paid when scheduled. If a firm suspends paying dividends, it must pay preferred shareholders in full before paying any dividends to common shareholders, said S&P Dow Jones Indices in a recent note.

Unique Advantages For EPRF

However, EPRF has its own set of advantages. As S&P Dow Jones Indices, investment-grade and cumulative preferreds, such as the issues found in EPRF, often have lower drawdowns during times of market stress than traditional preferred stocks.