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ETF Specialist

We'd 'Prefer' to Look Elsewhere for Yield

Preferred stocks' high yields may be alluring to income-seekers, but investors should approach this space with caution.

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With yield so scarce today, investors are branching out into different asset classes in the search for income. We’ve seen particularly large inflows into high-yield, corporate-bond, and REIT exchange-traded funds, some of which have doubled in size during the past year. Many investors have set upon preferred stock, which is a hybrid security usually issued by highly leveraged companies, such as financial institutions, telecoms, and utilities. Preferred stock has characteristics of both bonds and stocks. Like stocks, preferreds are traded daily on an exchange. Like bonds, they pay fixed income on a regular basis (usually quarterly) and do not benefit from earnings growth of the issuing company. In the capital structure, preferred stock is senior to common stock but junior to corporate bonds, and preferred shareholders have no voting rights.

The largest preferred stock ETF is  iShares S&P U.S. Preferred Stock Index (PFF). PFF is about 5 times the size of its nearest competitors and has greater liquidity. This fund’s wide range of preferred stock (almost 300 different issues are included) can be a satellite addition to a diversified income-seeking portfolio, and many have embraced it: PFF grew its assets by more than 2 billion dollars this year. Preferred stock is a good diversifier: It has low correlation to other income-generating asset classes like REITs, master limited partnerships, corporate bonds, Treasury Inflation-Protected Securities, and popular income ETFs like  Vanguard Total Bond Market ETF (BND) and  SPDR Barclays Capital High Yield Bond (JNK).

Abby Woodham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.