PFXF: Question & AnswerCoulter Regal, CFA, Associate Product ManagerAugust 12, 2021
In today’s yield starved environment, many investors have expanded their search for income to opportunities beyond traditional debt. Preferred Securities (preferreds) have been one such alternative income source that has seen growing attention. This blog is intended to answer frequently asked questions on preferreds and VanEck’s Preferred Securities ex Financials ETF (PFXF).
What is PFXF and Why Preferred Securities?
The VanEck Vectors Preferred Securities ex Financials ETF (PFXF) offers investors differentiated exposure to the U.S.-listed preferred securities market by tracking an index that excludes securities issued by financial companies, which historically have dominated broad-based preferred indices. Preferreds are hybrid securities that can offer investors a unique mix of both bond and equity like features. They have seen growing interest as of late, particularly for their potential high income profile as they may offer greater yield than that of a company’s common equity and senior debt. Additionally, preferreds have generally exhibited low correlations with equities and traditional fixed income instruments making them a useful diversifier in portfolios. Many investors use preferreds as a complement to their portfolio’s core fixed income allocation alongside or, in place of high yield debt. For more information on PFXF, visit the product webpage here.
What are Hybrid Securities?
Preferreds are considered hybrid securities (hybrids), meaning they have characteristics of both equities and traditional debt. Hybrids may give investors a fixed or floating rate of return and may pay returns as interest or as dividends. Some hybrids return their face value to the holder when they mature and others are considered perpetual, paying the holders for as long as the company is in business. There are many types of hybrid securities, but beyond traditional preferred stock, one of the more common types of hybrids are exchange-traded convertibles which, have some features of an ordinary bond, like a consistent income stream, but can also be converted into a predetermined number of common stock in the issuing company. This convertible feature allows the holder to benefit from rising share prices in the underlying stock.
Why Exclude Financial Preferreds?
After the financial crisis of 2008, banks began issuing a significant amount of preferred stock to meet the higher capital levels required by regulators. This proliferation of preferreds issuance by financials has led to an over concentration of the sector, which now makes up over 65% of the U.S. preferreds market.1 PFXF helps limit this unnecessary sector concentration by targeting preferred securities issued by companies that operate outside of the financial sector, offering differentiated exposure, without sacrificing yield potential, compared to most broad-based preferred strategies. Beyond increased sector diversification, ex financial preferreds also display a few other notable features, including an increased proportion of preferreds paying cumulative distributions and a lower proportion of preferreds with a call feature relative to financial preferreds.
Why are Many Preferreds Not Rated?
One characteristic that many investors notice when researching the preferred securities market is that much of the universe is not rated by the major credit rating agencies like Moody’s or Standard & Poor’s. This is largely because many preferred issuers simply chose not to pay rating agencies to rate their preferred/hybrid issues. There are a number of reasons that a company will choose not to have its preferreds rated that have nothing to do with the company's wellbeing, including they may already have a credit rating on much of their debt or their primary investors just don’t demand the ratings. Whatever the reason, choosing to not have a credit rating doesn’t necessarily mean the company's wellbeing is in jeopardy or that the preferred issue is bad risk. However, like any debt instrument, potential for default or delayed payment is still a risk that investors should weigh when considering an allocation to preferreds.
Does PFXF Pay Qualified Dividend Income?
Some preferred securities pay dividends that are treated as qualified income by the Internal Revenue Service, meaning they are taxed at the more favorable rate of long-term capital gains instead of ordinary income. Any qualified income received by PFXF from its underlying holdings will pass through to shareholders also as qualified income. The portion of the fund’s dividend that is considered qualified income will vary as the fund’s underlying holdings change overtime. Please visit VanEck’s Tax Center for more information on the portion of qualified dividend income paid by PFXF.
Are Preferreds Sensitive to Interest Rate Changes?
Preferred securities typically feature long-term maturities, typically greater than 30 years, or are even perpetual meaning they have no maturity. For this reason, preferred securities do exhibit some sensitivity to changes in interest rates. Notably, preferreds issued by financial companies tend to feature perpetual maturities more so than preferreds issued by non-financials. Excluding financial preferreds generally results in a lower portion of perpetual issues which may help lower overall maturity and reduce impact of interest rate changes. Additionally, the portion of a preferred portfolio that are callable or convertible and the timing of the call and conversion features can impact its interest rate sensitivity.
1 Source: S&P U.S. Preferred Stock Index (SPPREF). As of 7/30/2021.
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Authored byCoulter Regal, CFA
Associate Product Manager