2025 Guide: Preferred Stock ETFs Risks and Prices Unveiled

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Investors seeking consistent income often turn to preferred stocks, which blend characteristics of stocks and bonds, as an alternative to Treasury securities, corporate bonds, or bond ETFs. Preferred stocks appeal due to their higher dividends, attractive yields, and potential for capital gains compared to debt instruments.

Another benefit is the favorable tax treatment of preferred dividends, which may be taxed as long-term capital gains rather than ordinary income, unlike interest from Treasuries or corporate bonds. However, investors should be aware of IRS rules on qualified dividends, as not all qualify for these lower tax rates.

Key Insights

• Preferred stock ETFs provide attractive income but carry inherent risks investors must evaluate.
• Rising interest rates often lead to price declines in preferred stocks due to competition from safer securities like Treasury bonds.
• Call risk exists when companies redeem preferred shares, especially when interest rates drop.
• Popular ETFs like iShares U.S. Preferred Stock ETF (PFF) and First Trust Preferred Securities and Income ETF (FPE) offer exposure to preferred stocks.
• Concentration in financials and utilities can limit diversification in preferred stock ETFs.

While preferred stocks offer income advantages, it is crucial to understand their risks. Below, we analyze these risks and review two leading preferred stock ETFs: PFF and FPE.

Understanding General Risks

Preferred stocks are sensitive to interest rate fluctuations. Typically offering fixed dividend yields between 5% and 6%, their prices tend to fall when prevailing interest rates rise. For instance, if Treasury yields approach the dividend yield of a preferred stock, investors may shift funds to Treasuries, perceived as safer, causing preferred stock prices to drop.

Call risk is another consideration. Issuers of callable preferred stock can redeem shares at specified prices when interest rates decline, then issue new shares with lower yields.

Preferred stocks also carry liquidation risk similar to common stocks. In bankruptcy scenarios, creditors and bondholders are paid before preferred stockholders.

Important Note

Preferred stockholders have a higher claim on assets than common stockholders in liquidation events.

Specific Risks to Consider

Credit rating agencies such as Moody's, Standard & Poor's, and Fitch assess preferred stocks similarly to bonds. While some preferred stocks hold investment-grade ratings, many fall below BBB and are classified as speculative or junk.

Preferred stock ETFs vary in their exposure to investment-grade versus speculative stocks. Understanding an ETF’s investment strategy and sector allocation is vital, especially given sector-specific risks like those seen in oil and gas.

Popular Preferred Stock ETFs in 2024

iShares U.S. Preferred Stock ETF (PFF)

PFF is the largest preferred stock ETF with $13.6 billion in assets and a trailing 12-month dividend yield of 6.87%. It charges an expense ratio of 0.46% and tracks the S&P U.S. Preferred Stock Index.

Its 449 holdings are heavily weighted in financials (37.2%), insurance (13.7%), real estate investment trusts (13.2%), and utilities (10.9%).

Important

The heavy concentration in financial and utility sectors limits diversification, which may deter risk-averse investors concerned about exposure to financial crises.

First Trust Preferred Securities and Income ETF (FPE)

With $5.32 billion in net assets, FPE holds 246 positions and offers a 6.24% trailing dividend yield. This actively managed ETF carries an expense ratio of 0.85%.

Only 32% of FPE’s holdings are investment grade, while 65% are speculative grade and 3.37% unrated. The portfolio is concentrated in financials (banks 43.2%, insurance 19.3%), oil and gas (8.14%), capital markets (7.38%), and multi-utilities (4.06%).

Preferred Stock vs. Common Stock

Preferred stock represents equity ownership but differs from common stock by prioritizing dividend payments and asset claims without voting rights. Dividends are fixed as a percentage of investment, appealing to income-focused investors.

Trading Preferred Stock

Preferred stocks trade on exchanges with unique ticker symbols distinguishing them from common shares. For example, Alphabet’s common stock trades as GOOGL, while its preferred stock trades as GOOG.

Drawbacks of Preferred Stock Investing

Due to fixed dividends, preferred stocks are highly sensitive to interest rate changes. Rising rates can reduce market value and liquidity, forcing sellers to accept discounts.

Conclusion

Preferred stock ETFs specialize in preferred shares, offering higher income potential but also carrying risks such as interest rate sensitivity, call risk, and limited diversification. Investors should carefully assess these factors and ETF strategies before investing.

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