Fed Could Initiate The Push For Preferred ETFs

Among the high-yielding asset classes benefiting from the Federal Reserve holding off on raising interest rates to this point in the year are preferred stocks and the corresponding exchange-traded funds.

TheiShares S&P US Pref Stock Idx Fnd (ETF) (NYSE: PFF) has a 30-day SEC yield of 5.3 percent and is up 6.6 percent year-to-date. 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.

The Appeal Of A Preferred Stock

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.

However, investors' desire for income via preferreds could be tested in the near term. The August jobs report out Thursday could provide the Federal Reserve an avenue with which to soon raise interest rates. As it is, Fed fund futures point to a rate hike in December. Data suggest a rush away from preferreds could be painful because so much money has piled into ETFs such as PFF.

“The surging AUM mostly occurred since the start of 2015 as the asset class registered $10 billion plus of inflows. Preference stock ETFs were in fact the most popular fixed income asset class of last year in terms of relative inflows, as the $4.8 billion that flowed into the asset class over 2015 represented 30 percent of the AUM seen at the start of the year, more than any of the seven bond ETF asset classes tracked by Markit ETF Analytics,” said Markit in a recent note.

Ignorance Is (Rarely) Bliss

Of all the crowded trades market observers are pontificating about this year, think Treasurys, low volatility ETFs and gold, just to name a few, preferreds never enter the conversation. Ignorance is not always bliss, not a time when PFF has added $2.9 billion in new assets year-to-date, a fair percentage of its total AUM, and certainly not when the Fed could be nearing another rate hike.

Conversely, the benchmark ETF offering exposure to convertible bonds, the best-performing fixed income asset during Fed tightening cycles, has seen just $103.9 million in year-to-date inflows.

Clearly, investors like the promise of almost guaranteed income from preferreds, indicating they are not expecting the Fed to embark upon an all-out tightening cycle.

“The differing levels of investor enthusiasm towards the two asset classes shows that investors in the current market would rather pass on capital upside in order to receive the type of guaranteed income that made preference stock such a popular investment with Warren Buffet,” added Markit.