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One popular asset class for retirees and other investors seeking income is preferred stock. This makes sense as these shares are generally safer than common stock due to being higher up in the capital stack and the fact that an issuer cannot make any dividend payment to the common shareholders until it pays all the money that is owed to the preferred shareholders. However, preferred stock is considered a fixed-income security as the dividend that it pays is set in advance and generally does not vary with the performance of the company itself. As such, the price of these assets generally moves inversely to interest rates, which is one of the reasons that I recommended against investing in this asset class last year. However, that bearish thesis has now changed so investors seeking a secure income vehicle may want to consider putting some money into preferred stock. One way that this can be accomplished is through an investment in the Invesco Preferred Portfolio ETF (PGX).
About The Fund
As is the case with many, if not most, exchange-traded funds, the Invesco Preferred Portfolio ETF is a passively-managed fund that is designed to duplicate the price and dividend performance of an index of other securities. In this case, that index is the ICE BofAML Core Plus Fixed Rate Preferred Securities Index. The general way that passively-managed ETFs track their respective indices is simply by purchasing all of the securities in the index in the appropriate weightings. This is exactly what PGX has done so the holdings of the fund are the same as the index. Here are the ten largest positions in the ETF:
Source: Invesco
One of the first things that we notice here is that the index that is tracked by the fund includes a fairly large number of securities. This makes sense as many different companies issue preferred stock as a way to raise capital. This is also good for helping us avoid having overexposure to any single issue. As my regular readers on the topic of funds undoubtedly know, I generally do not like to see a fund have greater than a 5% weighting. This is because this is approximately the level at which a security begins to expose the fund as a whole to idiosyncratic risk. Idiosyncratic, or company-specific, risk is the risk that any financial asset has that is independent of the market as a whole. Thus, the risk here is that some event will occur that causes the price of some given asset to decline while the market itself does not. If that asset has too high of a weighting in the portfolio then such an event would have a very noticeable negative impact on the fund’s value. As we can see above, there are no assets in the fund that have a weighting above 5% of assets so investors in PGX appear to be relatively well insulated from this risk.
One thing that we do see here is that all ten of the largest holdings in the fund are issued by financial companies. In fact, the financial sector as a whole does account for an outsized portion of the total portfolio value:
Source: Invesco
The reason for this is that financial companies in aggregate are among the largest issuers of preferred equity. This is due to the fact that banks are able to consider money brought in through the issuance of preferred equity as Tier-1 capital, allowing them to look stronger in the eyes of regulators without needing to dilute the common shareholders or obtain high amounts of retained earnings. The fact that the fund does have significant exposure to the financial sector does present certain risks to investors, most notably if we get a repeat of 2008, but preferred stock is generally safer than common and it seems likely that governments will continue to backstop the banks. In addition, the increased regulatory scrutiny that we have seen towards American banks at least has rendered those institutions much safer than they once were.
We also see that utilities make up the largest proportion of the portfolio aside from financials. This is due to the fact that utilities are also major issuers of preferred securities as their stable cash flows provide the company with an easy method of making payments to the preferred stockholders and, unlike debt, the principal on preferred stock does not have to be repaid so the company does not have to worry about interest rate changes or bear markets or any other thing that may make it difficult to refinance its debt at an appealing interest rate years down the road. The fact that 12% of the fund consists of preferred securities issued by utilities does provide some safety for investors in the fund too. I discussed the reasons why in a previous article but for the most part it is that customers of the utility will generally do everything in their power to ensure that they pay the utility what they owe because nobody wants to have their power or heat cut off. Thus, these preferreds will likely provide the fund and by extension its shareholders with some income even during a financial system collapse.
We can gain further reassurance that the fund’s portfolio is generally safe by looking at the ratings of the preferreds in the portfolio. As is the case with bonds, the rating agencies also rate preferreds as these are also fixed-income securities. Here are what the agencies have said about the preferreds in the fund:
Source: Invesco
As we can clearly see here, fully 95% of the fund’s assets are rated investment grade, with fully 90% rated BBB or BB. These securities are therefore considered to have a very low risk of default, which should give some confidence to conservative investors that their money is likely to be reasonably safe invested in this fund.
Why Invest In Preferred Stock?
Around the middle of last year, I published an article (linked in the introduction) to this site suggesting that investors avoid preferred stock. However, in the introduction I suggested that I have reversed course on this conviction. The reason for this is the likely course for interest rates over the next year or two. In the middle of last year, the Federal Reserve was planning a series of rate hikes over the remainder of 2018 and 2019 that would eventually normalize rates in advance of the next recession. As preferred stock is essentially a fixed-income instrument with an unlimited duration, its price can be expected to move inversely to interest rates. Thus, in a rising interest rate environment, investors in preferred stock can be expected to see their principal decline.
However, earlier this year the Federal Reserve stated that it would not be raising interest rates during 2019. This was due to the market volatility that we saw during the fourth quarter of 2018 that showed us that the economy may not be able to handle higher interest rates. This has effectively undone my prior argument about declining preferred prices and should at least ensure that they remain steady over the course of this year while the dividends provide total return. While the central bank did not provide any outlook for interest rates in 2020 and it is still possible that there will be interest rate hikes then, I personally am somewhat skeptical of this and think that any future interest rate moves will be down. This results in preferred securities becoming a relatively solid asset for conservative investors seeking yield.
Distributions
As preferred stock is a fixed-income security that delivers all, or nearly all, of its total return through dividends, one might expect that PGX would boast a fairly high dividend yield. This is the case as the fund has a trailing twelve-month yield of 5.59%, which is one of the highest in the exchange-traded fund space. As is the case with other preferred stock ETFs like the iShares U.S. Preferred Stock ETF (PFF), the fund pays out its distributions on a monthly basis:
Source: Invesco
As we can see, the distribution does vary slightly from month to month, but it is usually reasonably steady. This is due to the fact that the ETF structure means that the number of shares that receive the distributions from the underlying securities is constantly changing as well as the fact that the preferred securities held by the fund usually pay their dividends quarterly causes the amount of cash available to be distributed to vary every month. With that said though, the distribution looks stable enough to keep most people happy.
Conclusion
In conclusion, the market environment for preferred stock has improved due to the Federal Reserve making the decision to postpone any further interest rate hikes for the remainder of this year and possibly indefinitely. PGX represents a good way to play this as the fund is reasonably well diversified and boasts a high monthly distribution that will likely keep income investors happy. In addition, the fund’s money looks to be invested in relatively safe securities, which will likely appeal further to retirees that want to preserve their capital. Overall, the Invesco Preferred Portfolio ETF may be worth considering.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
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