In the current environment of ultra-low interest rates, the
yield-hungry investors seek higher income from non-traditional
asset classes or instruments. One such asset class that has
attracted the investors' interest recently is the preferred
Preferred shares not only offer substantial yields (often
exceeding 6%) but also the opportunity for capital appreciation.
Investors have the option of investing in individual companies'
preferred stock or buying preferred stock ETFs which provide a very
convenient way to invest in a basket of diversified companies at a
low cost. (Read:
Invest like Mitt Romney with These Three ETFs
The investors should however remember that the high payout from
this asset class does not come without risks and they should
analyze the risk-reward characteristics of the various options
available in the space and then decide which ones suit their
Below we analyze the characteristics of this asset class, the
potential risks and some of the investment options in this space.
Three Excellent Dividend ETFs for Safety and
What is Preferred Stock?
Preferred stock is a hybrid security that has the
characteristics of both debt and equity. Preferred stock does not
have voting rights but has a higher claim on the assets and
earnings than common stock. That means that the dividends to
preferred stock holders must be paid before any dividends are paid
to the common stock holders and in the event of bankruptcy, the
preferred stock holders' claims are senior to common stockholders'
claims but junior to the claims of the bondholders.
Preferred stocks are either perpetual (without any maturity
date) or have long-term maturity (30 to 50 years). Like bonds,
preferred stocks are usually rated by rating agencies. (Read:
Complete Guide to Preferred Stock ETF
The preferred stocks pay the stockholders a fixed, agreed-upon
dividend at regular intervals, like bonds. Most preferred dividends
have the same tax advantage that the common stock dividends
currently have. However while the companies have the obligation to
pay interest on the bonds that they issue, the dividends on
preferred stock can be suspended or deferred by the vote of the
Trust Preferred Stock (TRUPS)
Trust preferred securities are issued mostly by the banks, which
create trusts to hold and service these securities. According to
the Federal Reserve, the trust preferred could be treated as 'Tier
1' capital by the bank holding companies. 'Tier 1' capital is one
of the most important measures of assessing the capital adequacy of
the banks by the regulators. By issuing Trups the banks can
raise their Tier 1 capital per regulatory requirements, while
deducting the interest payments for tax purposes. Further, these
shares do not have a dilutive effect on the company's common
shareholders and financial results.
Like fixed income securities, preferred securities are sensitive
to changes in the interest rates. In the event of rising interest
rate, the value of these securities will fall as these
securities behave like bonds as far as interest rate risk is
Many preferred securities have call provision, i.e. the issuer
has the right to redeem its preferred stock or convert it to common
Global X Joins Preferred Stock ETF Race with
The preferred securities also face credit risk as the issuer may
not be able to meet the claims of the investors. We may add that
most of the preferred shares do not enjoy a high rating and
not all preferred securities are rated.
Banks have been active issuers of preferred shares due to the
tax and capital advantage mentioned above. As a result, most of the
ETFs in this asset class have high exposure to the financial
sector, which has been very volatile in recent years.
In addition to high volatility, some of the recent regulatory
changes are also unfavorable for the preferred shares issued by the
Dodd-Frank Act seeks to restrict the ability of the banks to
recognize Trups as part of the core capital. Initially the smaller
banks had managed to get an exemption from the rule. However,
according to the
latest capital rules
proposed by the Federal Reserve, all banks will be required to
phase-out from Tier 1 capital of trust preferred securities and
cumulative preferred stock over a 10-year time period beginning on
January 1, 2013, in order to comply with the Basel III
We may add that while the banks are not required to call their
trust preferred securities, it is likely that the banks may call
some of these securities and replace them with new form of capital
in view of the current low-rate environment.
While keeping the above risks in mind, the investors can look at
the investment options in this space.
iShares S&P U.S. Preferred Stock Index (
remains the most popular and liquid preferred stock ETF, with
assets exceeding $9.9 billion and daily volume exceeding 200,000
shares. The fund charges 48 basis points in expenses and has
returned 12.8% year-to-date. Additionally, the fund has a very
attractive payout, with the current 30 day SEC yield at 6.07%.
While the ETF is well diversified with 268 holdings, almost 80%
of the holdings are in financial sector (mainly US banks and some
For investors looking to avoid exposure to the big US and
Global X Canada Preferred ETF (
is an option. Canada's banks are well managed, well regulated and
well capitalized. The World Economic Forum has ranked Canada's
banking system as the most sound in the world, four years in a
row. As a result of stringent regulatory norms and
conservative lending practices, the Canadian banks had emerged
largely unscathed from the global financial crisis.
The fund charges 58 basis points for annual expenses and has
gone up 5.34% year-to-date. Current 30-days SEC yield is 3.65%,
much lower compared with PFF. Further with just about $14
million in assets and daily volume of about 1,400 shares, the
trading costs for this fund are much higher.
If the investors want to avoid the exposure to financial sector
completely, they may consider the recently launched
Market Vectors Preferred Securities ex-Financials ETF (
which leaves out the financial sector. The expense ratio for
the ETF at 40 basis points is the lowest in this space. In terms of
sector exposure REITs and Electric occupy the top spots. (Read:
Market Vectors Debuts Preferred ex Financials
Current yield for the index is 6.78% and thus this ETF may be an
excellent option for investors looking for substantial income while
aiming to avoid banking sector specific risks
(see more in the
GLBL-X CDA PFD (CNPF): ETF Research Reports
ISHARS-SP PFD S (PFF): ETF Research Reports
MKT VEC-PR EX-F (PFXF): ETF Research Reports
GLBL-X SUPERINC (SPFF): ETF Research Reports
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