PFF: Currently only meaningful for diversification purposes (NASDAQ: PFF)
The iShares Preferred and Income Securities ETF (NASDAQ: PFF) holds preferred shares and hybrid securities denominated in US dollars. These are the preferred shares whose dividend payments were prioritized over common stock by some companies at the height of the Covid-induced uncertainty in 2020. Moreover, in a period where dividend growth remains uncertain due to macroeconomic concerns, the stability of the “preferred” is beginning to find some appeal.
However, since owning preferred stocks is analogous to owning shares of a company (since you can buy them the same way as stocks), they are subject to volatility and the ETF has suffered a 23% year-over-year decline, as shown in the chart below, which is much worse than the broader market represented here by the SPDR S&P 500 Trust ETF (SPY).
Still classified as a “taxable bond”, the PFF pays a decent yield above 5% and the purpose of this thesis is to assess other downside risks as well as perform a comparison with others in the class d fixed income assets.
First, I provide an overview of the current economic environment, highlighting the reasons for the attractiveness of ETFs.
The current environment
It remains a challenging environment as the Federal Reserve is determined to fight inflation, even to the point of orchestrating an economic slowdown, one of the side effects of which has been the volatility in global equity markets since the start of this year.
In this regard, the two- and ten-year yield curves remain inverted as shown in the chart below, which is illogical given that when you lend money (in this case to the US government), you should be more compensated for the long term (10 years) given the higher risk premiums. Here, the fact that you get a higher interest rate in the short term (2 years) indicates an anomaly that can predict a recession.
The resulting market pressure was not limited to risk assets or equities and also affected the bond market, with the iShares Core US Aggregate Bond ETF (AGG) falling nearly 18%. last year, as shown in the table below.
While bond prices have fallen across the board, yields have conversely risen. So credit or corporate bonds now compete with the US Treasury, so when you lend money to the government (which is safer than lending to private corporations) you get returns higher than 3.5% against less than 2% last year. An example is the iShares iBoxx $Investment Grade Corporate Bond ETF (LQD) which yields 3.28% and has to compete with the Vanguard Extended Duration Treasury ETF (EDV) which offers returns of 3.56% and billing fees of just 0 .06%.
In these unprecedented conditions and for those looking for better returns, the PFF paying 5.45% is starting to make sense for investors looking for income.
However, in this space, the preferred shares compete with the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) as shown in the table above, by offering a yield of 5.24%. However, high-yield securities are also referred to as junk bonds and, depending on the severity of credit conditions, can be subject to large market fluctuations, putting an investor at greater risk of default ( or loss of his investment) than to an investor. higher-rated or higher-quality debt securities.
Risks and Mitigation Measures
Nevertheless, investors are reminded that in the event of liquidation, when a company’s assets must be auctioned off to pay off creditors, bonds take precedence over stocks, or even preferred stocks. For this reason, the preferred and hybrid securities held by PFF fit better into a portfolio as a diversifier from fixed income securities. For example, holders of investment grade or treasury bonds wonder where to invest their money after the market goes down.
At this point, it is important to point out that hybrid securities such as convertible bonds tend to offer a combination of debt and equity characteristics. As a result, their value is skewed towards the price action of the stock into which they are convertible, which in turn implies that there are risks of capital depreciation, especially when markets are volatile. Now, this can be mitigated to some extent by PFF issuers using preferential treatment for “capital”, namely by not calling them (redeeming them) when rates fall. This can be likened to sacrificing higher dividend yields for capital gains.
To illustrate my point, I make a comparison with the Invesco Preferred Portfolio ETF (PGX) which pays a higher dividend yield of 6.22% and only allows a credit rating by Fitch ranging from AAA ( highest) to D (lowest). On the other hand, PFF held 20.84% of unrated bonds as of October 19, which explains why SA attributes a less favorable risk profile to it than PGX.
However, in practice, the Invesco ETF has been more volatile than the PFF since 2008, as shown in the chart below, this period including the Great Financial Crisis and the Covid stock market crash. Thus, PGX (in orange) underperformed PFF (in blue) by more than 12% despite its higher quality assets.
Moreover, a comparison of total returns which includes dividend payments in case these are reinvested and included in the price performance, shows that the iShares fund with a performance of 68.34% beat its counterpart Invesco by more 30% since 2008.
So over the long term, PFF may have had low dividend-yielding monthly distributions, but conversely suffered less capital depreciation and delivered better total returns.
To be realistic, investors will also note that this is not a similar comparison as the two ETFs track different indices, with PFF tracking the ICE Exchange-Listed Preferred & Hybrid Securities Index while it is the ICE BofAML Core Plus Fixed Rate. Preferred Securities Index for PGX. Additionally, with assets under management of over $14.32 billion, despite only launching a year earlier in 2007, PFF has seen much higher levels of inflows than PGX with $5.12 billion.
Then, for those who wish to invest, I try to plot the evolution of the prices.
The way to go
First, since preferred shares pay dividends, their value is particularly sensitive to higher interest rates. Therefore, while the U.S. Central Bank has aggressively hiked rates, the allure of PFFs has faded for income seekers and that is likely to continue this year as it remains a hawkish Fed with a mandate to controlling inflation. So, from 3.08% currently to a likely target of 4.5% to 4.75% by spring 2023, it is probably futile to “hope” for a break in interest rate hikes in 2022. However, as we approach 2023, global economic and geopolitical factors will increasingly play a role in determining monetary policy actions, including the effect of a strong dollar on the rest of the world.
Second, the preferred and hybrid stocks held by PFF are also influenced by the performance of the stock market. Today, the ETF is heavily weighted towards financial services at 46%, including banking and insurance, followed by electric utilities at 12.2% and REITs at 11.8%, as shown below. -below.
Third, with such a high exposure to Financials, as shown in the orange chart below, PFF’s share price was heavily skewed towards this sector, as shown in the deep blue chart, but the decline was partially mitigated by exposure to the utilities sector (pale blue graph) which was relatively untouched by market turmoil with a year-over-year loss of just 4.29%.
Fourth, with the U.S. consumer remaining resilient amid slowing growth, lenders JPMorgan (JPM), Bank of America (BAC), and Wells Fargo (WFC) managed to increase its revenue and profit margins in the third quarter of 2022, as it was able to lend more money to its customers.
Today, rising interest rates are benefiting large banks, especially those with larger retail operations, but their stock prices have not been favorably impacted as the overall economic climate remains gloomy. Thus, Goldman Sachs (GS) analysts are neutral on the financial sector. Additionally, they are also neutral on real estate and utilities, while reducing exposure to technology.
Therefore, with a combined 70% exposure to the financials, real estate, and utilities sectors, PFF stock price might find some support around the $30 level. Additionally, scoring a “B” for the asset flow metric means there is more money coming in than going out of the fund.
On the other hand, there could be volatility with interest rate decisions scheduled for the first week of November due to the Fed’s aggressive approach. In this regard, the momentum indicators show further decline, perhaps to the $28 support level last seen in the spring of 2020.
Therefore, considering the points above, those primarily looking for predictable cash flow as part of a fixed income diversification strategy may choose PFF, which pays monthly distributions. Thus, for the same amount invested, the PFF provides a higher income than investment grade, junk or treasury bonds according to the table above.
Plus, unlike common stock, PFF holdings have preferential rights to dividend distributions, meaning that in times of financial stress, you have a better chance of getting paid. Moreover, with economic uncertainty, it is better to take refuge in the stability of preferred shares than to hope that companies will increase dividends on common shares. Finally, the iShares ETF has a history of better capital preservation.