Don't Abandon Preferred ETFs

As investors digest the fact that the Federal Reserve is increasingly determined to raise interest rates following its December meeting, a plethora of rate-sensitive asset classes, sectors and exchange-traded funds are likely to come under intense scrutiny.

Just look at last week's repudiation of utilities stocks and ETFs. Similar treatment could extend to real estate stocks and ETFs, as well as master limited partnerships, long duration bonds and other favored areas of income generation.

The same probably holds true for preferred stocks and ETFs such as the iShares S&P US Pref Stock Idx Fnd (ETF) PFF.

Maybe Don't Ditch...

However, income investors might not want to be too hasty in ditching PFF and rival preferred ETFs, even as interest rates climb.

Related Link: Come Together: Low Volatility Meets Equal-Weight In These ETFs

“While it is true that preferred stocks may see price declines as traditional long-term bonds would, the losses may be more than offset by the potential yield. Additionally, because we expect the rate rises to be gradual, we wouldn’t expect to see big downward spikes in preferred prices. Preferred stocks may also be attractive due to the fact that they’re issued mainly by financial companies, like banks. That’s because banks have historically tended to do well in rising rate environments, as they can benefit from making loans at higher interest rates,” according to a recent blog post by BlackRock, PFF's issuer.

Income Investors And Preferred Stocks

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.

Of course, sensitivity to rising rates comes by way of a bond's duration; the longer the duration, the more sensitive it is to fluctuations in interest rates.

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, though preferred shareholders are higher on the totem pole in the event of issuer bankruptcy or default than are common equity holders. In the case of PFF, the ETF is undoubtedly tempting with a trailing 12-month yield of almost 6.2 percent.

“Because preferred stocks have a fixed dividend and may not fluctuate the way common stocks do when the market changes, they can potentially reduce the overall volatility of an equity or high yield portfolio. Keep in mind, however, that preferred stocks are more volatile than traditional fixed income and can carry more risk when financial sectors are under pressure,” added BlackRock.

Although investors may be fretting about higher interest rates, that mentality is not reflected in their treatment of PFF; the ETF has added nearly $526 million in new assets since the start of the fourth quarter.