Alternative To Preferred Stock ETFs

With a historically low interest rate environment for the last five years, ETFs holding preferred stock have been a favorable destination for yield-seeking income investors.

Overview: Preferred Stock

A preferred stock is a type of security that offers characteristics of both bonds and equities. Preferred shares fall between common stock and bonds, in that they have an income aspect to them and can also provide capital appreciation.

In terms of hierarchy, preferred stocks are below corporate bonds and above common stocks. In layman's terms, the holder of preferred stock would be paid before the holder of common stock, but after corporate bondholders.

With the Fed looking to raise rates sometime in 2015, now would be a good time to reassess preferred stock investments. As interest rates rise, investors may start to roll out of preferred stock ETFs in search of yield in other asset classes.

Related Link: LPL Financial Economist: It's Now "Very Difficult" For The Fed To Raise Rates In June

PowerShares Variable Rate Preferred Portfolio

A way for investors to stay in preferred stock ETFs during an environment of rising interest rates is the PowerShares Exchange-Traded Fund Trust II VRP. The 10-month old ETF has the characteristics of a traditional preferred stock ETF; however, it incorporates "hybrid securities," which have a floating rate, allowing it to account for changing interest rates.

As the Fed raises rates, the interest paid by hybrid securities will also increase, a phenomenon often referred to as floating rates.

VRP is composed of 91 preferred stocks that cover six sectors. The financials make up the majority of the portfolio at 87 percent, with energy coming in at 5 percent. The top holdings include:

• Wachovia Capital Trust III at 3.9 percent
• Citigroup Capital XIII making up 3.7 percent
• GMAC Capital Trust I Fixed Rate Floating Rate Trust ALLY coming in at 3.3 percent

VRP has a 30-day SEC yield of 4.82 percent and a yield to maturity of 4.47 percent. The ETF has an expense ratio of 0.50 percent.

Related Link: Colony Capital Inc. Announces Preferred Stock Offering

iShares U.S. Preferred Stock ETF

For comparison, the largest preferred stock ETF in the market is the iShares S&P US Pref Stock Idx Fnd (ETF) PFF, which gives investors exposure to a basket U.S. preferred stocks. The ETF is made up of 312 holdings across 15 sectors, with banks at 38 percent and diversified financials at 16 percent being the most heavily weighted sectors.

The top individual holdings include:

• HSBC Holdings plc (ADR) HSBC at 2.4 percent
• GMAC Capital Trust I making up 1.7 percent
• Barclays PLC (ADR) BCS totaling 1.7 percent as well

PFF has a 30-day SEC yield of 5.48 and an expense ratio of 0.47 percent.

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