Readers who have been following my work will know that I hold a substantial position in the Invesco Variable Rate Preferred ETF (VRP). I started purchasing this ETF back in early 2022 when I was worried that interest rate increases were on their way. Investors familiar with fixed income investments like bonds and preferred shares will understand that the economic value of fixed income securities drops when interest rates (technically yields) are rising. Therefore, by my reasoning, a floating/variable rate preferred stock fund was likely going to protect my capital from such rate increases.
It all made a lot of sense at the time, but it didn’t quite work out as I had anticipated.
VRP lost value as the Federal Reserve launched the rising interest rate cycle – and not just pennies – the ETF dropped in value by some 15%. I think my main mistake was in underestimating the lag time in the resetting of the floating rate dividends. The dividends didn’t instantaneously rise as interest rates did. That led VRP’s market price to unexpectedly flounder.
Now, in the past few months, I’ve been researching alternatives for my capital invested in VRP because floating rate securities theoretically aren’t the best place to be when interest rates decline (and rates are expected to decline soon).
In researching VRP a little closer, it turns out that my instincts were wrong again (or so I think)! My analysis revealed that, in fact, VRP’s dividends should actually increase over the next 6 months, even if the Fed cuts rates. This variable rate ETF was substantially more attractive than I had expected to find. So I’ll be holding on to it until at least the winter. I encourage opportunistic yield investors to go take a look at my July 19 article on VRP.
In the medium term though, I want to find a suitable preferred stock alternative to VRP. Today, this search brings me to the iShares Preferred and Income Securities ETF (NASDAQ:PFF) which, at least according to eftdb.com, is the largest preferred stock ETF out there.
Let’s review this ETF and see how it stacks up against my requirements.
PFF basics
As mentioned, PFF is a large ETF for its category, with an AUM approaching $15 billion. The ETF was launched in 2007 and has returned an average of 3.67% since inception. Now, that will look like a terrible return, but let’s remember that the United States held a zero interest rate policy (ZIRP) for about 9 of the past 15 years. Fixed income returns have been hard to come by, except in the past couple years.
The 1-year return for PFF has been a much more appealing 8.36%. This coincides with the (seeming) end to the rising interest rate cycle.
Exposures
The most common issuers of preferred shares are financial companies, and for this reason, most preferred share funds, except the strategically allocated VanEck Preferred Securities ex Financials (PFXF) are heavily weighted towards financial issuers. This is indeed the case with PFF, which is ~75% concentrated in preferred shares of financial firms.
author, using holdings data
The other critical exposure datapoint that most investors will be looking for is the duration of the ETF. Unfortunately, iShares/BlackRock do not disclose the duration for PFF, which I find a bit puzzling, to be honest. That’s normally a pretty critical measure that investors of fixed income securities would like to be armed with before making an informed choice, but it’s not offered here. Other investors/analysts have searched for PFF’s duration measurement in vain.
Always trying to be of service to investors, let me attempt to MacGyver PFF’s duration by looking at relative price movements.
I’ve charted above the price movements of several preferred share ETFs, including PFF, the First Trust Preferred Securities and Income ETF (FPE), the Invesco Preferred ETF (PGX), the VanEck Preferred Securities ex Financials (PFXF) and the Invesco Financial Preferred ETF (PGF). The period I chose was Oct 29, 2023 to March 10, 2024, a period during which the Treasury bond yields dropped fairly steadily.
The stated durations for these funds, according to Morningstar, are:
author, using Morningstar data
As should be expected, the ETFs with the largest durations had the greatest performance over the period of declining yields, with PGX on top delivering a 20% total return over less than 6 months! PFF’s return over the period was 2nd lowest of the group, but performance closely mirrored the VanEck ex-Financials ETF (PFXF). Morningstar suggests that PFXF has an effective duration of 5.79, so let’s ballpark PFF’s duration at about 5.75.
PFF Outlook
ETFs carrying fixed-rate dividends preferred shares, such as PFF, will benefit from declining yields, and as shown above, they already have. Treasury yields appear to have topped out near Halloween of last year. Hence, the recent positive returns.
Seeking Alpha
As investors know, the FOMC is widely expected to lower the Fund Funds rate by an amount of 50bps to 75bps by the end of this year, with rate cuts continuing in 2025.
CME Group
There are a few important questions here for investors.
How will the yield curve (~longer-term maturities) react if the FOMC proceeds with continuous decreases in the Fed Funds rate? Remember, the Fed Funds rate is the short-term rate that banks lend to each other at. The yield curve is currently inverted (2-year yield exceeds the 10-year yield), and baseline thinking would be for the yield curve to return to an upward-sloping formation once the FOMC conducts a few cuts to the Fed Funds Rate. If that’s the case, holders of mid-term/long-term fixed income securities may not see much forward benefit in terms of capital appreciation.
If, however, the economic picture worsens considerably, as some are anticipating, then investors could see additional declines in longer-term yields. In that scenario, preferred share ETFs like PFF could see additional share price upside.
If longer-term yields do not decline further, that doesn’t automatically mean that PFF investors are out of luck, though. Investors holding this ETF would likely continue to earn a dividend in the ~6% range, much better than PFF was certainly offering a few years ago.
That, ultimately, is my baseline outlook for PFF at this point: a ~6% to 6.5%-yielding portfolio of preferred shares. I’m not anticipating much capital appreciation (lower long-term yields) at this point.
Recommendation: PFF versus VRP
After analyzing PFF, I remain firmly in the VRP camp (Invesco Variable Rate Preferred ETF) for now. As I had anticipated (see July 19 article), VRP recently announced an increased monthly dividend (of $0.1166, up from $0.1093). That offers it an annualized run-rate of about 5.9%. Yes, that’s a lower yield than PFF is offering, but I’m expecting continued dividend increases for VRP through to the end of 2024. It’s very possible for VRP’s monthly dividend to reach or exceed $0.13 as additional resets kick in (yes, even as SOFR falls as the FOMC lowers the Fed Funds rate), delivering up to a 7% yield at today’s market price of $23.80.
As a result, I land on a Hold rating for PFF, while I maintain my Buy rating on VRP. That VRP Buy rating might change towards the end of the year if I decide that this ETF’s dividends have topped out. At that point, I might consider switching some of my funds to PFF.
Notable Risk
A major risk to keep in mind for both PFF and VRP, along with most other preferred share ETFs (except PFXF) is their heavy exposure to the financial sector. If the economy swoons and banks start having credit problems, these preferred share ETFs could see material downside.
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