Why investors should be careful investing in preferred stock ETFs

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Oct. 15 2014, Updated 8:00 a.m. ET

Preferred stock exchange-traded funds (or ETFs)

Investors usually want to cash-in on the regular and high-yields offered by preferred stock ETFs. The yields are offered amid a low-interest rate regime. So far this year, preferred stock ETFs—like the iShares S&P U.S. Preferred Stock Index Fund (PFF) and the State Street’s SPDR Wells Fargo Preferred Stock ETF (PSK)—have outperformed broad market indices like the S&P 500 (SPY).

Preferred stock ETFs pay assured dividend returns. Equity ETF returns fluctuate with the performance of the underlying equity basket.

pref stock etfs vs spy

What’s a preferred stock ETF?

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A preferred stock is a type of hybrid security that has bond and stock-like characteristics. It pays regular dividends like a bond. However, it has perpetual existence like a stock. Preferred stock is usually issued by financial institutions, utilities, and telecommunication companies. Within securities, preferred shares are higher than common stocks. They’re lower than corporate bonds.

Interest-rate risk

While preferred stocks provide investors with an attractive source of yields, they’re vulnerable to rising interest rate environments. Like bonds, preferred stock becomes less attractive in a rising-rate environment. When market interest rates rise, preferred stock holdings decline in price to bring their yield up to an attractive level. They’re perpetual in nature. They usually expose the investor to significant interest-rate risk.

Liftoff closing

The U.S. Fed scheduled to end its asset purchases at its next meeting. This is assuming that macroeconomic progress remains on track. In such a scenario, investors aren’t seeing signs of an interest-rate liftoff anytime soon.

The Fed’s communications have suggested that they will likely keep the federal funds rate at zero lower bound for some time—even after the end of asset purchases. They haven’t specified a time.

Investors in preferred stock ETFs—like the SPDR Wells Fargo’s PSK and BlackRock’s (BLK) PFF—should exercise caution. Investors should be careful as the U.S. economy nears a liftoff in its market interest rates. This could erode ETF prices.

As interest rate liftoff uncertainties increase in the U.S. market, another asset class that offers stability in income is the category of dividend ETFs. We discussed dividend ETFs and how they act as a hedge against stock market bubbles in our series, “Why dividend yield matters in the current market.

Goldman Sachs (GS), one of the largest global investment banking firms. On September 19. it filed with the U.S. Securities and Exchange Commission (or SEC) to get permission to launch its own actively-managed dividend ETF. We’ll discuss this in the next part of the series.

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