Preferred equity investments have grown in popularity over the past few years as income-seeking investors search for high-yield assets in a very low-yield market. Most preferred equities trade at yields of 5-6% or greater which is far better than investors will find in the bond market and even among most “high dividend equities.”
Of the major preferred equity funds, the Global X U.S Preferred ETF (PFFD) is one of the best as it has the lowest expense ratio of 23 bps and has generally outperformed its peers. This can be seen below when compared to the Invesco Preferred Portfolio ETF (PGX) and the iShares Preferred and Income Securities ETF (PFF):
As you can see, PFFD is the winner by a slight margin. Frankly, the majority of investments and exposure is the same for each of the ETFs, but PFFD’s expense ratio is 20-30 bps lower, so it tends to outperform.
Like most Global X yield-oriented ETFs, PFFD pays its dividend monthly at a rate of $0.114 per share. At a price of $25.5 today, this corresponds to a compounded yield of 5.5%.
In my opinion, PFFD is the best preferred equity ETF of the bunch, but it may not be a great time to buy the fund. With interest rates re-touching an all-time low and inflation signals on the rise, fixed-rate funds like PFFD could suffer significant devaluation. As I’ll explain, If investors are looking for more stability, they may be best off looking into floating-rate investments.
A Look at PFFD’s Exposure
Like most preferred equity funds, PFFD has very high exposure to the financial sectors since banks tend to issue more preferred equity than others. This and the credit quality of its holdings are illustrated below:
As you can see, the fund has high exposure to financials, utilities, and real estate which are all high-capital-intensive industries. In general, these industries have less cyclical economic exposure than the others; however, the opposite was true in 2008.
Interestingly, financial preferred equities generally have higher yields than non-financial preferred. This can be seen below with the VanEck Vectors Preferred Securities ex Financials ETF (PFXF), which has a lower 5.15% yield while PFFD has the highest of the bunch at 5.4%:
Not only does PFFD have a higher dividend yield than its peers, but it also has a more stable price trend with less volatility. PFFD’s credit risk ratings are essentially the same as that of its peers with a high concentration in the BB- to BBB+ range (essentially, standard credit risk), but it has a higher exposure (25% of holdings) to fixed-to-floating-rate and variable-rate preferreds which are generally less volatile in price since their dividend changes.
Given historical increases in credit risk spreads in recessions and PFFD’s credit risk exposure, in a major recession it is likely that its yield would climb to 8-12%. This would cause a principal drawdown of roughly 32-55%. While this may seem large for a 5.5% return, it is less than PFF’s 65% drawdown in 2008-2009.
Keep in Mind Inflation Risk
In my opinion, inflation is a “hidden risk” in preferred equities. Investors seem generally aware of the potential impact of a recession, but there is little discussion regarding the high inflation risk in preferred equities today.
75% of the holdings in PFFD pay a fixed-rate with no term and 23% are fixed-to-float/variable, both of which carry more inflation risk than most fixed-rate bonds with a duration less than ten years.
The yield on a 10-year U.S. Treasury bond is generally considered free of credit risk but has high inflation risk. In general, the U.S. 10-year Treasury pays the expected inflation rate (1.6% or so today) plus a small real-return which usually reflects the yield curve.
As you can see below, the dividend yield on PFFD and PFFD’s peer PGX generally tracks the U.S. 10-year Treasury:
While the relationship is not always clear, a 1% move in the 10-year generally results in a similar 1% move in preferred equity dividends. Other factors include changes in credit ratings and the yield curve, but the 10-year Treasury determines the major trend. Of course, the major determinant of the 10-year Treasury is inflation expectations.
Inflation expectations can be measured as the 10-year Treasury yield minus that of the inflation-protected 10-year Treasury. As you can see below, this rate tends to be inversely correlated with preferred equity values:
As you can see, when inflation expectations dropped in 2014-2016, PGX rose from $13.6 to $15.2. When they rose again in 2016-2018, PGX dropped back to $13.6. Inflation expectations fell back down after the 2018 correction which has boosted the value of preferred back toward all-time-highs.
Some investors may believe that inflation expectations are headed lower. Of course, preferred equities are only a good investment if inflation is falling. However, the market may be very wrong about inflation. As you can see below, the Treasury market’s implied inflation rate is far below that actual U.S. inflation rate:
The breakeven inflation rate is currently at 1.6% while the U.S. inflation rate is 2.5% and the core inflation rate (which excludes food and energy) is at 2.26%. While the breakeven inflation rate has a significant impact on bond and preferred equity prices, it is actually not that great of a forward predictor of inflation. In general, the trend in core inflation is a superior inflation predictor.
So, if Treasuries are mispricing inflation by about 80bps-1.2% then PFFD’s (and peer ETFs) dividend yield is artificially low by 80bps-1.2% and is likely to bounce from here. If that occurs, it will likely bring PFFD around 1% lower back to 2018 lows (likely $23).
The Bottom Line
As a fund, I like PFFD more than all other preferred equity ETFs since it generally outperforms with its slightly higher dividend yield and lower expense ratio.
That said, as an investment, I do not believe it is a good buy today. While investors may be conditioned to believe that a 5.5% yield is high, today’s preferred equity yields have never been this low in U.S. history. While it is certainly much better than a 10-year Treasury at 1.5%, it does not mean investors should accept it.
The problem with low yields on preferred equities is two-fold. Most obvious is that you get less income. However, the more important one is that the drawdown risk to your principal is much higher since yields are highly unlikely to go lower (due to inflation being mispriced and the generally high likelihood of a recession over the coming few years). If yields cannot go any lower, they can only go higher which means that PFFD (and others) can only decline in value.
This risk can be mitigated with floating-rate investments that do not carry inflation risk since their payment increases with short-term rates (which increase with inflation). Of these, I believe the best are the lower-risk shorter-term floating-rate corporate bond ETF (FLOT) and the higher-risk senior loan ETF (BKLN). In general, the credit risk in BKLN is about the same as it is in PFFD but with even more exposure to financials.
As you can see below, PFFD has outperformed both since rates/inflation has fallen, but I suspect the opposite to be true going forward when rates pop back up:
Overall, I believe that PFFD and its peer ETFs are “sells.”
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in PFFD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.