H igh-yield bond ETFs and mutual funds have stoked a lot of recent chatter, not all of it good. Meanwhile, smart investors have quietly bid up exchange traded funds holding preferred stock, a hybrid security.
Preferred stock ETFs are an ideal choice for investors seeking income with low volatility, says Monish Shah, head of ETF trading at Mizuho Securities.
"Preferred ETFs have been outperforming high-yield debt and winning the race consistently and quietly," Shah said. "Yet we haven't heard many people talking about this asset class."
Preferred stocks have characteristics of both equity and debt.
Like bonds, they have a fixed or variable coupon that is distributed as a dividend. But like stocks, they hold the potential for capital appreciation or depreciation.
In terms of claim in the event of bankruptcy, they stand above equity but below bonds. And they hold priority over common stock in the payment of dividends.
The two ETFs moved more or less in sync in the first half of 2015. Then JNK plunged as oil prices started to collapse.
The energy rout has worsened conditions in the credit market. This month, high-yield spreads hit a level not seen since June 2012, Russ Koesterich, BlackRock's global chief investment strategist, wrote in a Dec. 21 note.
"Fears regarding high yield are increasingly leaking over into equity markets," Koesterich said.
Credit Risk Vs. Interest Risk
Junk bond ETFs are loaded with debt issuers from the capital-intensive energy and telecom industries, Shah told IBD.
JNK, for example, holdsConsol Energy ( CNX ) bonds.
Preferred ETFs, in contrast, focus on financials and "have hardly anything in energy," Shah said. He added that 85% of PGX holdings are banks and diversified financials.
That may make preferred ETFs a solid choice for successful investing from a credit-risk perspective.
Banks such asWells Fargo ( WFC ), whose debt PGX holds, are poised to see their bottom lines go up (and credit risk go down) in a rising rate environment.
From the perspective of interest rate risk, both preferred stocks and high-yield debt are vulnerable. Their prices may fall as rates go up.
Edge In Duration
However, preferred ETFs have a small edge in terms of duration -- 4 years vs. 4.5-5 years for high yield, Shah said.
Overall, he expects a slow pace of Fed tightening that should not be alarming for either type of ETF on a longer-term basis.
For preferred ETFs, an improvement in credit risk may neutralize the effect of the Federal Reserve's rate hikes in 2016.
Moreover, investors in PGX and its peer ETFs are taxed on dividends at a far lower rate. That can make "a massive difference" in long-term portfolios, Shah said.
He believes the tiny size of the preferred stock market may be obscuring its opportunities. It holds just $422 billion, while the corporate debt market has $8 trillion.
Its outperformance this year, coupled with its risk profile, may help it find a way into investors' ETF strategies .
PGX yields 5.89% vs. 6.32% for JNK. It rose on the stock market today .
Longer term, some preferred stocks' risks include their callability. Also, their price-gain potential is generally less than that of common stocks.