Preferred Stock ETFs: Fiscal Cliff Rebound Play?

Prior to Monday's market rally, fears of the fiscal cliff had been wreaking havoc on even the most conservative dividend-paying sectors. In the process, even stodgy telecom and utilities ETFs were taken to the woodshed. With concern running high that a higher dividend tax rate could prompt many companies to forgo dividend increases, the negative price action for these dividend sectors was understandable. Worse yet, that negativity was widespread throughout the universe of decent-to-high yield securities. In other words, it was not surprising to see ETFs tracking preferred stocks get caught in the downdraft. Take the case of the $10.5 billion iShares S&P U.S. Preferred Stock Index Fund PFF. PFF has a 30-day SEC yield of 5.71 percent and a beta against the S&P 500 of just 0.46, according to iShares data. Those are two factors that have almost certainly increased the allure of this ETF in a yield-starved environment. However, those traits did not prevent the fund from tumbling as fiscal cliff fears rose. The problem: Probably and excessive weight to financial services stocks. In the case of PFF, various financial services names account for approximately 85 percent of the fund's weight. PFF's exposure to European banks has made matters all the more difficult recently, but the struggles of this ETF and its rivals obfuscate a critical fact. That being the hybrid nature of preferred stocks. Preferreds are not common stocks, nor are they completely debt products either. Rather, preferred stocks share traits of both bonds and common stocks. The "a ha" moment as it pertains to the fiscal cliff comes from realizing that a company that is paying a preferred dividend had bigger make that payment or risk damage to its credit rating. There is one of the bond aspects of preferreds. A company that is consistently in arrears on preferred dividend payments risks a lower credit rating and that leads to higher borrowing costs. The way of explaining this scenario to a second-grader is: "Even if the fiscal cliff comes to pass, why would any company risk damage to its credit rating just because the dividend tax went up?" It is not a good trade. With that in mind, here are some of the more obscure preferred stock ETFs that might prove durable even in a post-fiscal cliff world. Global X Canada Preferred ETF CNPF The Global X Canada Preferred ETF is the first ETF devoted to Canadian preferreds, an asset class that should prove desirable because Canadian banks are far less controversial than their U.S. counterparts. That does lead into an important point and that is CNPF is not all that different from a U.S.-focused preferred ETF in that financials account for over 70 percent of this ETF's weight. Energy and telecom names represent most of the rest of CNPF's sector allocations. The thesis here is simple: International stocks have shareholders in other countries that will not be affected by the fiscal cliff. Meaning international dividend ETFs, of which CNPF is one, could prove to be an excellent fiscal cliff survival tool. Plus, CNPF pays a monthly dividend. PowerShares Preferred Portfolio PGX No, it is not fair to refer to an ETF with over $2 billion in assets under management as "obscure," but the PowerShares Preferred Portfolio is somewhat overlooked in comparison to some of its larger rivals. PGX amounts to a good news/bad news type of ETF. Follow along. Good news: 30-day SEC yield of 6.52 percent. Bad news: More than 91 percent allocated to financials. Good news: PGX pays a monthly dividend. Bad news: A third of the ETF's holdings have non-investment grade ratings. The good news is that PGX can be summed up with two positive tidbits investors need to acknowledge. The overall credit quality of its portfolio is superior to that of PFF's and the ETF's beta is far below that of its iShares rival. Market Vectors Preferred Securities ex Financials ETF PFXF The Market Vectors Preferred Securities ex Financials ETF is a case study in how a new ETF that is entering an arena fraught with competition can be successful. Following its July debut, PFXF has $92.3 million in AUM and those inflows have likely been driven by two simple factors. First, PFXF has an expense ratio of 0.4 percent, meaning it is the cheapest preferred ETF on the market. Second, the fund is not excessively weighted to bank stocks. The exclusion of traditional banking names means a less volatile fund. Simply put, PFXF is doing something right. Since its debut, the fund has outperformed all of the other ETFs highlighted here. For more on ETFs, click here.