Retirement Income Portfolio:  Preferred Stock ETFs

Preferred stocks are high yielding investments that can participate in market upside, but can also offer some protection in the case of a market crash.  Sound like the perfect retirement income investment?! Not exactly, but preferred stock ETFs can play an important role in a diversified retirement income portfolio.  This post discusses how preferred securities work, the potential risks and rewards, and compares some low cost Preferred Stock ETF options.  

The Basics

Most companies use equity and bonds in order to raise capital for the organization, but some companies also issue preferred stock.  Preferred stock really is a little bit of a combination of stocks and bonds.  Like a bond, preferred stocks pays a fixed regular dividend.  Like an equity, preferred stock can appreciate (or depreciate) in price.  Many companies issue preferred stock because debt covenants don’t allow additional debt to be issued, and technically, preferreds are considered an equity and not a debt of the company.  Therefore, preferreds are typically issued by companies with higher debt levels already, with financial and utility companies being large issuers of preferred stocks.  

The Pros

High Yield: If you are buying preferred stock, you are really doing it for the yield. As I mentioned before, preferred stocks can be a great investment for retirees looking for income.  Preferred stocks typically yield over 5%, which is higher than most bond and dividend payments.  

Steady income: Preferred stocks are ahead of common stock (but behind bonds) on the corporate structure pecking order. Although the divided can be cut, they tend to be more stable and secure than the dividend of a common stock.  If a company cuts it dividend, many preferreds require the preferred stockholders are paid past dividends before the common stock starts dividend payments.  

Lower volatility than common stock: Although preferred stocks fluctuate up and down in value, like a stock, they tend to be much less volatile than the company’s common stock.  As we will see later, preferred stock ETFs have about half the volatility of the stock market.  

Taxation: Most preferred stock dividends are taxed at the more favorable capital gains tax rate as opposed to bond interest which is taxed as ordinary income which is typically higher.

Risks

Market: The biggest risk with preferred stock is market risk. Although preferreds tend to be less volatile than the stock market, it doesn’t mean they don’t lose value. In 2008, iShares US Preferred Stock ETF (the largest preferred stock ETF) lost 24%. This is less than the 37% the stock market lost, but you probably don’t feel great about seeing these type of losses as a retiree.

Interest rate: Like any high yield investment, preferred securities are interest rate sensitive. They tend to do better when rates go down and struggle when rates rise. This could be an issue if interest rates increase. Preferred securities have very long term maturities, many times over 20 years or no maturity at all. This can subject them to higher interest rate risk.

Callable: Preferred securities are issued at a par price (usually $25) and if rates decrease enough the issuer can many times call back the security at the par price. This can limit the price appreciation as you may be concerned that your stock may be called at a lower price. As investors have craved high yielding investments over the past few years, preferred stocks have increased in value which makes call risk even greater.

Preferred Stock ETF Options

Comparing the three largest preferred stock ETFs

Name Ticker Expense Ratio Size Yield
iShares US Preferred Stock ETF PFF 0.47% 18.1B 5.75%
PowerShares Preferred Portfolio PGX 0.50% 5.5B 5.66%
First Trust Preferred Securities and Income ETF FPE 0.85% 3.1B 5.38%

Source: Morningstar as of 11.24.17

Performance

Ticker Year-To-Date 1-Year 3-Year 5-Year 10-Year
PFF 8.89% 8.91% 4.83% 5.54% 6.16%
PGX 11.30% 10.79% 6.92% 6.59%
FPE 11.00% 11.65% 7.83%
Benchmark: S&P 500 18.36% 20.45% 10.23% 15.46% 8.41%

Source: Morningstar as of 11.24.17

Risk

Ticker Standard Deviation Sharpe Ratio Sortino Ratio
PFF 4.07 1.09 1.86
PGX 4.12 1.55 2.55
FPE 3.66 2.03 3.93
Benchmark: S&P 500 10.06 1.03 1.91

Source: Morningstar as of 11.24.17 (3-years)

iShares US Preferred Stock ETF (PFF):  iShares has the largest preferred stock ETF and one of the cheapest with an expense ratio of just 0.47%.  Unfortunately, that size may be becoming a hindrance as PFF has trailed some of its competitors over the past few years.  PFF is the worst performing and worst risk-adjusted performer of the three that we compared.  The preferred stock market is not a huge market, compared to the equity and bond markets, and the size of PFF may make it difficult to find attractively valued preferred shares to purchase. Still it has a good long-term track record and the only fund that we compared that made it through a very difficult 2008 for preferred stocks.   

PowerShares Preferred Portfolio (PGX): PowerShares Preferred Portfolio is similar to PFF in risk level, but returns have been superior over the past 1, 3 and 5 years.  Fees are slightly higher and yield is slightly lower, but the performance makes up for the higher costs.  At a third of the size of PFF, it appears that PGX may have an advantage over PFF in finding deals in the preferred market.  If you are looking for a traditional preferred stock portfolio, it appears that PGX is a better option than PFF at this time.  

First Trust Preferred Securities and Income ETF (FPE):  FPE is really a different animal than the other two strictly preferred ETFs that we discussed previously.  First, it holds nearly 30% of the portfolio in bonds and only 70% is preferred stocks.  Second, only 50% of the portfolio is U.S. and the other 50% is international.  The other two options that we looked at are 100% U.S. preferred stock.  FPE is also a fairly new fund, only getting its start in 2013.  Still, it is hard to argue with the results.  FPE has by far the best risk adjusted returns and even more impressive is its downside performance, as measured by the Sortino ratio.  The 30% bond allocation explains why it has done so well protecting on the downside, but it has also done a fantastic job outperforming the other 2 funds when things are going well too.  The 30% bond portfolio is mainly floating rate bond funds, which tend to do a little better when interest rates rise.  This helps offset the interest rate risk inherent to preferred stocks that we discussed earlier.  

In Summary

The record low interest rates of the past decade has made preferred stocks very attractive. As a retiree, a steady stream of high dividends are just what the doctor ordered to increase the yield of your portfolio. Still, the popularity of preferreds has increased the price of preferred stocks which has lowered the yields and increased risks. Although preferred stocks have many characteristics of bonds, they tend to be much more volatile. Preferreds can play an important role in a retiree income strategy but be careful of chasing yield and buying into an asset class, like preferreds, that has had a great run over the past few years.

Disclaimer:  This article is for education purposes only and does not imply a recommendation to buy or sell any securities.  I, or my clients, do not hold any of the previous securities mentioned and do not intend to initiate a new position.  

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