PFF: Bigger Is Not Always Better (NASDAQ:PFF)

Summary

Preferred shares are difficult to analyze and value given their quasi-debt and equity characteristics. When risk-free rates are low, the instruments provide higher yields than bonds with lower volatility than the common shares of the same company. When rates rise the prices fall more than bonds given their equity traits, i.e. companies do not need to pay the dividends nor the principal. At the current juncture in the US rate cycle, it appears preferred shares may offer higher risk-adjusted gains than corporate bonds. I analyzed the largest ETF in the sector, the iShares Preferred and Income Securities (NASDAQ:PFF) to gauge its current yield and potential under different rate scenarios. Under the assumption that 10-year treasury yields declined to 3% the ETF may have a 13% capital gain potential plus 7% in yield pick-up. However, this ETF does not appear to outperform peers or high-yield bonds.

Performance

I compared the PFF performance to the US Treasury (7-10 year maturity) and US High yield since the ETF’s inception and found that junk bonds have had a better long-term total return. The UST was far less volatile leading up to the Fed’s current inflation fighting cycle, which may call into question conventional wisdom that US government debt is the most secure.

In the second and third charts, I compared PFF’s performance vs. selected peers that had a 10-year track record vs. pure price and total return metrics. As can be seen, the PFF is consistently at the bottom of the group. The First Trust Preferred Securities and Income ETF (FPE) did best, which may be due to its active and global strategy vs. US Indexing.

Peers & Indexes

There are not many preferred share-focused ETF to choose from, and many track broad indexes that generally are dominated by the financial sector that benefits from the temporary nature of that preferred capital affords them. As can be seen in the table below, Intercontinental Exchange (ICE) provides nearly all the indexes for the preferred ETF segment.

Preferred shares nuances

The securities are generally issued by a company to reduce leverage, i.e., instead of taking on an obligation to pay back a set amount at a future maturity day plus interest, a company issues preferred shares with high and established dividend payments. The advantage to the company is that they never need to pay back or call the preferred shares. In addition, a company may have many different issues, each with varying characteristics, which makes selecting the instrument as important as the company.

Most preferreds are issued at US$25 or par with a set coupon yield. Some have call options, floating rates, convertible to common stock, may accumulate dividends due, etc.. Each has a different characteristic that can be beneficial or negative depending on the rate cycle and the company’s financial health. A preferred share can lose all of its value if the company cannot pay dividends, enters into default, etc.

Bond Characteristics

The asset class also has many bond characteristics such as duration and yield to worst (YTW) that help identify potential return and risk. Duration is the volatility of change vs. the risk-free or benchmark rates, i.e., the US Treasury, expressed in years. A duration of 1 year means that the value of the preferred may increase or decrease by 1% for every 100 basis points the US Treasury changes. The YTW is the rate or yearly yield that a preferred will generate to the earliest call date that also incorporates the price appreciation to par or call price. Thus, generally speaking, the higher the duration and greater the YTW the greater the volatility.

Finally, bonds and preferreds can and do rise beyond par or maturity redemption value during the life of the instrument, based primarily on the predominating current risk-free rate. A long-term bond with a 5% coupon at par or 100 can rise to 125 if benchmark rates fall to 4% which means that at 125 the coupon is equal to 4%. This is a simplified example, the pricing mechanism of bonds depends on its duration, rate, and call features as well as credit quality.

Portfolio Overview

The PFF is a passive fund that tracks the ICE index, which has over 400 issues but focused on 150 companies. I downloaded the index, which is heavy in the financial sector, and calculated the current YTW of 6.8% with a duration of 9.4 years and a weighted average price 8% below par. Below is a condensed snapshot of the index and by default the PFF. Note that the prices are scaled to 100.

Rate Sensitivity

Preferred stocks are mostly valued as bonds and fluctuate with rates and capacity to continue paying their stated dividend yield, i.e., credit quality. I conducted a rate sensitivity analysis to gauge the impact on prices if risk-free rates or the 10-year treasury declined, maintaining the risk spread. Given the duration of 9.4 years, this portfolio has a high degree of volatility and upside potential in a Fed easing cycle. I calculated a total return upside potential of 20% if the 10-year treasury fell to 3%.

Conclusion

I rate the PFF a hold. The long-term track record is less than appealing vs. peers and alternative fixed income ETFs such as high-yield bonds, while the passive strategy in this segment is a hindrance given the multitude of nuances from one issue to another of the same company. The preferred asset class is better served with active management, in my view. However, the ETF should perform well in a declining rate scenario and warrants a Hold rating.