Which Is The Best Investment: PFF Vs. IPFF – iShares International Preferred Stock ETF (BATS:IPFF)

(Source – Pexels)

The iShares International Preferred Stock ETF (IPFF) seeks to invest in a global portfolio of preferred stocks. The keyword here is “seeks”; roughly 85% of the fund is invested in Canada, particularly Canadian financial institutions (72%). Perhaps the ETF should be re-labeled “CPFF” to be more accurate in its investment holdings.

To the south is the iShares U.S. Preferred Stock ETF (PFF) which is invested in a portfolio of U.S. preferred stocks and has similarly high exposure to financial institutions.

Let’s do a head-to-head match up with these two ETFs to see which is the better investment.

There will be three main categories of our competition:

1. Value (i.e., Yield);
2. Credit Risk (potential credit quality appreciation); and
3. Global Asset Exposure

Points will be awarded for each sub-category out of 5 for a maximum total of 15 points for each fund. Let the best investment win!

Value: Bang for the Buck

The current dividend yield of PFF is a strong 5.75% while IPFF is a still decent 5.1%. The dividend payments of both funds have also been relatively stable. At first, it would seem like the essentially Canadian IPFF has inferior value to PFF, but Canadian interest rates are roughly 60 bps below that of the United States. Thus, on a direct interest rate adjusted basis, PFF and IPFF are paying equivalent dividend yields.

Let’s take a quick look at that interest rate differential to see if there are any informational trends. Here is the difference between the U.S. Treasury 30 year and the Canadian 30-year equivalent:

(Source – Investing.com)

As you can see below, this trend is generally reflected in the PFF-IPFF dividend yield differential:

Data by YCharts

Overall, we can see that U.S. yields have recently taken a nosedive compared to those of Canada. To a certain extent, the PFF-IPFF dividend differential lags that of the U.S.-Canada 30-year yield.

We can also see that U.S. yields are on a strong downtrend compared to those of Canada. On one hand, it means you could have gotten a much better yield if you bought in January 2018. On the other hand, the strong downtrend back into negative territory indicates that PFF investors have been seeing greater capital appreciation from lower yields.

To finish this section, PFF currently has an expense ratio of 0.46% while IPFF has a higher expense ratio of 0.55%. I’m personally not one to care about a 9 bps difference, but because the two are so close in yields, it matters for scoring.

Overall, I will award 3 points for yield to the U.S. PFF ETF and 2 points for IPFF. PFF, in general, pays higher yields than IPFF and has a lower expense ratio. Of course, if current trends of lower U.S. yields continue, then the two would be equivalent. In my opinion, fair yields for each would be closer to 7% and I expect yields to eventually creep in that direction. Let’s move over to “Growth Potential” to see which fund is likely to have better future credit risk and possible capital appreciation.

Principal Growth Potential

The down-trending U.S. yield exists for one of two reasons: Government pressure on lower interest rates, and/or falling credit quality for Canadian holdings compared to their U.S. counterpart.

In order to asses this, we will take a sample of the top holdings for each fund and look at their common credit risk measurements. Note, we have a mix of financial and non-financial companies in each so we will analyze the financial and non-financial credit risk independently. This is done because of financial institutions have far different balance sheets than non-financials.

Here are the credit risk fundamentals for the top holdings for IPFF on top and PFF on bottom:

(Note: “inc” denotes the number of years increasing or decreasing for the left-adjacent column. This lets us see the trend of the given measurement.)

(Data Source – Unclestock)

To make the results of this data more clear, let’s look at the averages for each. We can then take those averages for non-financial and financials (for each ETF) and then weight them according to what percent of the total fund is financial or non-financial in order to best represent the fund as a whole. For example, 67% of IPFF is financials so the “total holdings average” is 67% * financial average + 33% non-financial average. See below:

(Self-sourced)

Overall, the general bankruptcy risk is very similar for each. Olson O-Score, a probability of bankruptcy measure, is nearly the same for each while the Altman Z-score bankruptcy risk measure is slightly better for PFF. They also have very similar return-on-assets and operating efficiency (OPEX/Revenue).

Overall, general solvency and efficiency are the same for both, but I’ll have to give the win to IPFF. When breaking down all the average in a Z-score fashion and creating a score based on all metrics, IPFF wins not because it has better solvency now, but because its holdings are trending in the right direction while those of PFF’s are trending toward lower quality. This may mean lower interest rates for the companies in IPFF in the future and greater present value for the ETF.

Revenue growth over the past 12 months was substantially better for IPFF than for PFF. Further, IPFF holdings are paying down their debt at a faster rate than those of PFF and are improving operational efficiencies and return on assets. Since the two are admittedly close and both frankly don’t have great numbers, I’ll award 3 points to IPFF and 2 points to PFF. This brings the total for both at 5.

Let’s see if global macro exposure can break this tie.

Global Macro Exposure

I’m not one for ties, but as my readers may know, global macroeconomic exposure is one of my favorite subjects so we should be able to break the tie.

To begin, IPFF is much more volatile than PFF with an average annualized standard deviation of 10.25% and 5.15%, respectively. This means that, historically speaking, investors in IPFF have experienced essentially twice as many up and down movement as investors in PFF. This is certainly a major blow to IPFF.

Let’s have a look at the systemic macro-asset exposure that may be causing this higher volatility. Here is the systemic exposure for IPFF and PFF based on “Multiple least squares” betas (or slopes) to each asset class:

(Data source – Google Finance)

As we can see, IPFF is extremely negatively correlated to the U.S. dollar and the euro because IPFF is primarily exposed to the Canadian dollar. PFF, on the other hand, has much more balanced exposure between stocks and bonds. From this perspective, PFF is a clear winner because it has roughly 1/3 of the total systemic exposure as does IPFF.

That said, it would be fairer to judge IPFF on a currency-hedged basis. Investors in IPFF would be smart to open a USD/CAD position not only to hedge Canadian dollar currency risk but also receive that extra 60 bps difference in interest yields. This could also be done through shorting the Invesco CurrencyShares Canadian Dollar Trust ETF (FXC) in an equal amount to your IPFF position. Of course, this is more work than many are willing to do and not capital efficient, but still important for analysis.

Here is the result:

(Data source – Google Finance)

We still see high negative exposure to the euro and the dollar likely because of the balance sheet currency exposure of the companies in IPFF. Overall, when measured this way, IPFF has lower bond and equity exposure than PFF which is a plus, but much higher foreign currency exposure. Also, after using the currency hedge, the volatility of IPFF drops from 10% to 8% which is still considerably higher than PFF at 5%.

Overall, I’ll have to give the win for this section to PFF. The U.S. dollar and the euro have been seeing increasing volatility recently and a strong upward move in the dollar could greatly hamper IPFF.

I actually like the asset exposure of both quite well. A great thing about preferred equity is it is very balanced between stocks and bonds. For example, falling equities are negative for preferred shares because they raise credit risk. That said, lower equities typically also cause interest rates to decline which raises the present value of the preferred shares. In this manner, they are not too exposed to either bonds or stocks. Almost like real estate and utilities but even more bond-like. Thus, I will give PFF a 5/5 for asset exposure and IPFF a 3/5 due to its high currency risk exposure.

PFF Takes Home The Medal

PFF is our winner with 10/15 points compared to 8/15 points for IPFF. The big positive factors for PFF are the slightly superior yield, lower expense ratio, and lower global asset exposure/volatility. The big positive factor for IPFF is the ongoing improvements in the fundamentals of the companies it holds.

Personally, I’m bullish on interest rates and bearish on equities. I know that sounds impossible, but I expect growing monetary problems to create inflation in the next downturn. Accordingly, I would not go long on either right now. That said, I may be interested in a long PFF, short IPFF pairs trade to take advantage of PFF’s edge in a risk-hedged manner. I am also bullish on the U.S. dollar and see this as a proxy trade to it.

Here is the recent performance of that pairs trade with dividends not included:

Data by YCharts

If the trend is truly our friend, this trade may be a good one. We can see here that PFF has been appreciating at a much faster rate than IPFF as interest rates in the U.S. have been on the decline. This pairs trade also has a positive 0.46 bps dividend yield differential. Of course, stock lending fees are likely to be greater than this so there is unlikely to be positive carry in this trade. Still, if actively managed well, it could be profitable.

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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.