PFF: No Need For A Heavy Financial Preferred ETF

The iShares Preferred and Income Securities ETF (NASDAQ:PFF) is a very popular preferred stock ETF. According to eftdb.com, PFF is the largest preferred stock ETF by assets with $16.2 billion in assets under management and towers over the next two largest preferred stock ETFs, First Trust Preferred Securities and Income ETF (FPE) with $6.8 billion in AUM and Invesco Preferred ETF (PGX) with $5.9 billion in AUM. However, I would rather construct my own preferred “fund” as it is easy to build a safe, secure preferred stock portfolio.

I utilize multiple ETFs in my portfolio construction, but mostly do so when either the strategy is difficult to replicate as a retail investor, such as VanEck Morningstar Wide Moat ETF (MOAT), or the strategy focuses on an industry of which I don’t feel overly comfortable making specific recommendations, such as iShares Expanded Tech-Software Sect ETF (IGV). For full disclosure, my bride just received an inheritance that was managed by the typical Wall Street wrap-fee broker who invested the portfolio in sector ETFs only, including PFF and PGX.

Preferred stocks are usually bought for income in the portfolio, and many issues are higher yielding, but not as secure, as corporate bonds from the same company. Within the pecking order of debt/equity hierarchy, preferred stocks are ranked between bonds and common stock. Most preferreds have a few basic security terms which are important characteristics to properly appreciate what you are buying.

• Call Date: Many preferred issues have a date at which the company will buy back the preferred issues, much like a maturity date of a bond. The call date is the date at which the preferred stock can be redeemed for cash. Some issues have a mandatory feature where, much like their bonds, the company must redeem their preferred series. For many issues, the company has the option to call the stock, but it is not mandatory, and the stock can continue to trade past the call date with the company retaining their option to call at any time.
• Par Value: The price at which the company can call the preferred issue, usually priced at $25, $50, or $100 a share.
• Cumulative dividend: Like common stock dividends, the Board of Directors must approve the quarterly dividend payments for preferred stocks. In times of economic stress, the preferred dividend can be suspended. Unlike its common stock cousins, preferred shares will many times offer a “cumulative” provision whereby the suspended payments accrue to be paid at a later date. The amount in the arears much be settled before any common stock dividend and regularly scheduled preferred stock dividend payment is made.

Armed with these terms, it becomes fairly easy to develop a matrix for researching preferred issues. I find quantumonline.com to be a great source for preferred research, but like most internet financial sites, it does have its holes. Quantumonline is an easy place to research to individual preferred stock terms.

In late 2019, I began to switch out of a 7-year ladder of date-specific corporate bond ETFs and into a portfolio of preferred stocks. As a bond replacement in my personal portfolio, I went looking for a combination of safety and higher yield. My first screen is for cumulative vs non-cumulative provisions, with the requirement of being cumulative only. Since I am giving up the ability for dividend increases with my preferred stock choice, I restricted the selections to only those issues which offer the investment protection of making me whole on distributions during the most stressful of economic times. Of interest is this simple investment protection requirement, which leaves most banks off the list. With the financial bailout during the Great Recession of 2007-2010, one of the government requirements was banks are forbidden from issuing cumulative preferred stock. I have little regrets for eliminating an entire economic sector from my preferred portfolio as I believe the safety of cumulative vs non-cumulative warrants their exclusion.

I have developed a preference for the somewhat unique investment situation of regulated utility preferreds. First, corporate profits of utilities are regulated by the government and the preferred distributions are considered as secure as their common dividends. Utility preferreds are included in the equity calculations during rate setting negotiations. Since any cost savings created by replacing higher yielding preferreds with lower yielding issues is considered as a savings to be passed on to ratepayers, there is much less incentive for utility companies to call their preferred issues, even during times of low interest rates. For instance, I own a utility 5.28% preferred issue which was callable in 1967, or more than 55 years ago, and is still trading – albeit with limited liquidity. Second, during utility mergers often the acquirer will buy all the common (voting) shares but will leave the preferred (non-voting) shares as actively trading. When the acquired company becomes an operating subsidiary, the terms of the acquisition could dictate that the outstanding subsidiary preferred share dividends are paid to investors before any funds are transferred up to the parent. Third, some utility subsidiary preferred issues are extremely small in comparison to the overall financial status of the much larger parent. The same subsidiary issue with the 1967 call date feature has a total market value of $7.4 million, according to quantumonline, but whose parent has an enterprise value of $52 billion. These illiquid issues should be used only as long-term income holdings as the ability to buy and sell shares is extremely limited.

However, I am not restricted to just the utility sector. While utility preferreds comprise 75% of my preferred stock allocation, I also own industrial companies with strong cash flows to support the cumulative dividends.

Returning to iShares Preferred and Income Securities ETF, their portfolio is very heavy to the financial sector with ~65% of assets invested in the sector and utilities represent only ~12% of assets. The remaining 9 sectors combined represent the balance 23%. Since banks can not issue cumulative preferreds, it could be determined the majority of PFF portfolio does not offer the income safety of cumulative provisions. I find this to be unacceptable and is a major reason for my Sell recommendation.

My portfolio is segregated into 4 investment buckets titled: Cash and Equivalents, Bonds, Equities Bought Primarily for Capital Gains, Equities Bought Primarily for Income, and Sector ETFs. As of July 1, my personal allocation included 43% of income portfolio is in preferred stock issues and 57% in high yielding common stock which were purchased for income over capital gains, such as utility common shares. Of the 43% in preferreds, 75% is currently invested in utility preferreds and 25% in various industrial firms with strong cash flow to support their cumulative dividends.

Full personal disclosure: We recently received distribution from an inheritance trust which was managed by one of the big brokers. The distributed portfolio was mostly in sector ETFs along with a smattering of income ETFs, with PFF and Invesco Preferred ETF included. I sold half the position in PFF with the proceeds going to increase the individual preferred shares portfolio and to build up the Cash allocation. I expect to nibble out of the balance of PFF as a source of capital for other investments. In addition, I have a position in First Trust Preferred Securities and Income ETF and it has been a recommendation in Guiding Mast Investments. The attraction is the diversified nature of FPE assets, including a large exposure to foreign securities. The portfolio consists of 120 bond positions and 200 preferred stock positions, with 43% being non-US issues.

While there is an attraction to PFF from an ease of adding preferred shares to a portfolio, the simplicity of buying PFF does not outweigh the risks of its portfolio income during times of economic stress. If there was a SA stock recommendation to “Reduce” or “Lighten Up” over “Sell”, that would be a more appropriate recommendation.