Last July, I wrote two articles for Seeking Alpha in which I examined six of the most popular preferred stock ETFs. In the first of those articles, I considered the Invesco Preferred Portfolio ETF (PGX) alongside two of its competitors. In response to a lively discussion in the comments of that article, I penned a second article in which I looked at another three preferred stock ETFs that, in my estimation, were somewhat less appealing. A few months later, in November, I was invited to revisit the VanEck Vectors Preferred Securities ex Financials ETF (PFXF) in a follow-up piece for Seeking Alpha. In each of those articles, my disclosure statement remained the same: I am/we are long PGX. Today, I would like to revisit the one preferred stock ETF, out of the six I have evaluated, that resides in my portfolio to see if now is a good time to add to, close, or maintain my position.
Why Invest in Preferred Stock?
For the benefit of readers who may not be as familiar with preferred stock, I think it is important to review some of the basic reasons investors might want to include it in their portfolios. Preferred stock is a rather unique type of equity that might best be described as a hybrid investment vehicle combining characteristics associated both with bonds and common stock. Like bonds, preferred stocks tend to appeal to income-oriented investors seeking a steady, predictable stream of cash. While preferred stock can appreciate or depreciate, shares have a par value that tends to prevent them from trading outside of a comparatively narrow price range. Thus, preferred stock rarely offers investors much in the way of capital appreciation. Instead, it offer investors a substantial yield, often well in excess of 5%. Furthermore, preferred stockholders enjoy preferential treatment in the event of a company’s financial distress. If, for instance, a company must liquidate its assets to pay its creditors, bondholders will be paid first, followed by preferred stockholders. Common stockholders will get whatever is left, if anything. Similarly, when a company suspends or cuts its dividend to common shareholders, preferred stockholders will continue receiving their checks. Lastly, preferred stockholders often benefit from qualified dividends that are classified as capital gains rather than ordinary income.
Why Preferred Stock May Not Be Right For You
Those benefits understandably appeal to many income-oriented investors, but there are some significant downsides to investing in preferred stock that must also be taken into consideration when looking to initiate or add to a position. As I mention above, preferred stock almost never offers investors significant capital appreciation. Thus, if you’re seeking growth, you’d best look elsewhere. Another drawback to preferred stock that investors may want to consider is the very real possibility that a company will issue a share call. Like bonds, preferred stock generally has a maturity date set decades in the future. However, after five years, a company can call the outstanding shares of its preferred stock, which they will often do if it is financially advantageous for them to do so. They’ll pay you the par price and you’ll have lost an income stream. A third consideration investors will want to keep in mind before buying preferred stock is interest rate sensitivity: When interest rates go up, the appeal of preferred stock tends to weaken. In a rising interest environment, common stock becomes more appealing because they can offer higher yields while the fixed yield of preferred stock may even pull their share prices down – and prices can drop hard. With the Fed slashing interest rates in 2019, this last consideration might not seem all that pressing, but it is well worth bearing in mind when looking at preferred stock.
The Pros and Cons of PGX
Pro #1: Yield. Because investors looking into preferred stocks are primarily interested in generating an income stream, the first thing I look at when evaluating preferred stock ETFs is the fund’s yield. PGX has consistently offered an appealing yield well north of 5%, often surpassing the rate of its closest competing fund, the popular iShares U.S. Preferred ETF (PFF):
Con #1: Credit Risk. While both funds offer investors a solid stream of monthly payouts, PGX’s yield has consistently been a little bit higher than that of PFF. This difference is largely attributable to the fact that PGX assumes a slightly higher credit risk than PFF, with a full 64% of its holdings rated BBB and another 28% rated BB:
PFF, by contrast, allocates more than one third of its portfolio to AAA-rated stocks and only 30% to BBB- and BB-rated preferred stocks. Thus, while I would hardly call PGX a risky investment, potential investors should note that the fund has a slightly riskier credit profile than its closest competitor. If you are comfortable with that, PGX will reward your risk tolerance with a little extra cash. That’s certainly a plus.
Pro #2: No Mandatory Convertibles. Of the three funds I mention in this article, PGX is the only ETF without any mandatory convertibles in its holdings. Whereas nearly a quarter of PFXF’s holdings and around 11% of PFF’s holdings are mandatory convertibles, PGX holds none. Because such shares convert to common equity, they inject a degree of risk into funds like PFXF and PFF that can result in the sort of volatility conservative fixed-income investors consciously seek to avoid. PGX, then, may strike some income seekers as a more stable option than some of its peers.
Con #2: Low Diversification. A second risk potential investors may want to consider when looking to buy PGX is the fund’s lack of diversification. As opposed to the aforementioned PFXF, which markets itself as a diversified basket of preferred stocks deliberately excluding the financial sector, both PGX and PFF are highly concentrated in financials. Of the two, PGX is significantly less diversified, with more than 64% of its holdings in the sector:
When compared with PFF, which also maintains a high concentration of holdings in financials, PGX’s limited sector diversification is even more apparent:
Thus, PGX is particularly vulnerable to disruptions in the financial sector and investors wary of the financials sector may understandably want to avoid PGX.
Pro #3: The Taxman Takes Less Money.
While some people may be wary of PGX’s concentration in the financial sector, the fund’s lack of diversification does offer one significant benefit: qualified dividends. Qualified dividends are dividends that are taxed as capital gains rather than the rates on non-qualified dividends. Because financial institutions tend to issue more preferred stock that offer qualified dividends than issuers in other sectors, nearly 80% of PGX’s dividends are qualified. In other words, PGX’s investors keep more money than investors who buy shares of a fund like PFXF (which has less than 10% of its holdings in preferred stocks paying qualified dividends).
Con #3: The Expense Ratio is a Bit High
According to the Wall Street Journal, the average expense ratio for an ETF is 0.44%. Of the three ETFs I mention in this article, only PFXF, with an expense ratio of 0.41% falls below this number. PFF comes close to that number, clocking in a hair over the average at 0.46%. Meanwhile, PGX is a bit high at 0.52%. This means that, for every $1,000 you invest in the fund, PFF will charge you $4.60, PGX will charge $5.20, and PFXF will cost you $4.10. While $1.10 out of a thousand dollars might not seem like much, it adds up over time and some investors may find that PGX’s higher expense ratio may detract from the fund’s higher yield and lower tax numbers.
I own PGX and have no plans to sell at the moment. I like the monthly dividends and I appreciate the fund’s tax implications. With the coronavirus currently rocking the market, comparatively boring fixed-income investments such as preferred stocks tend to provide a modicum of stability in tumultuous times. While there is a small amount of credit risk in PGX’s portfolio and while it is highly concentrated in financials, the fund’s holdings are unlikely to be impacted by the wider market’s volatility, even as major financial players such as Mastercard (MA) are cutting revenue forecasts in response to the virus’s impact on travel. Even in the event of a prolonged decrease in travel and an accompanying drop in revenue among the issuers of the preferred stock in PGX’s basket, the very nature of preferred stocks ensure that you will continue being paid each month, even if the common shareholders worry about their investments. For this reason, I would consider adding to my position of PGX rather than putting money into a market in the midst of a stomach-churning sell-off.
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Disclosure: I am/we are long PGX, MA. 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.