PFFD - PFFD: I'd Buy As 'Higher For Longer' Narrative Fades

2023-12-20 20:07:13 ET

Summary

• Global X U.S. Preferred ETF is a fund that invests in high-yield preferred stocks, which have recently seen a price crash due to Fed rate hikes.
• With the Fed abandoning its "higher for longer" narrative, this could provide an opportunity for investors.
• The fund offers diversification and safety through a basket of over 200 preferred stocks, with a focus on financial companies.
• While preferred stocks have risks, such as low liquidity and credit quality concerns, PFFD offers stable dividends and a low expense fee.

Global X U.S. Preferred ETF ( PFFD ) is an income fund that invests into preferred stocks with a high yield. The fund used to have a pretty stable price around $25 but it crashed in the last couple years as the Fed started to hike rates and signaled that it was determined to keep rates higher for longer. Now that narrative seems to be collapsing as the Fed is already signaling 3 rate cuts for next year and more for 2025. It may be time to buy this fund again while it's still on sale.

Preferred stocks are not exactly bonds but they trade like bonds. They usually go up in price when bond yields drop and drop in price when bond yields rise so they behave almost exactly like bonds do in most situations. Of course they don't offer the safety of bonds since companies don't "default" if they miss a dividend payment whereas they would default if they missed an interest payment of a bond. Still, if you buy preferred stocks of companies that are in good financial shape, you wouldn't have to worry too much about it. What's even better is a fund that owns a large number of preferred stocks from a large number of companies which offers the safety of diversification.

This fund aims to do just that. It holds a basket of more than 200 preferred stocks with average yield around 7%. When you look at the top holdings of the fund you will notice that a lot of them are issued by big banks such as Wells Fargo ( WFC ), Citibank ( C ) and JPMorgan ( JPM ). This shouldn't surprise anyone since financial companies are more likely to issue preferred shares. This allows these companies to issue more shares and boost their assets without diluting their common shareholders because preferred stocks don't count in the number of diluted shares for financial companies but they may still count as a liability in their balance sheet depending on its structure.

Preferred shares can come in different shapes and sizes. They can have a maturity date where they convert into cash. Some of them may also have a date by which they convert to regular shares. There are preferred shares with fixed rate payments as well as variable rate payments. Some preferred shares are perpetual so they go on forever with no maturity. These shares can also be recalled by the issuing company under different circumstances. Some preferred shares will count as "debt" on a company's balance sheet just as bonds do while others will count as 50% debt and 50% equity. This also depends whether the company issuing them is classified as a "financial corporation" or not. It can become difficult for investors to worry about all these details and their tax implications, which is why it may be a good idea to buy a fund that comes with a basket of preferred shares.

To make the matters worse, preferred shares tend to have low volume and low liquidity which means they can have wide bid-ask spreads. Preferred funds and ETFs typically don't have that problem because many of them have plenty of liquidity. This could be another reason to buy a fund over picking your own preferred shares.

When we look at the sector breakdown of PFFD we see that 75% of its holdings are in Financials which is not surprising after seeing that 8 out of the top 10 holdings were from banks. The fund also contains a small number of utilities, communication services (mostly AT&T ( T )) and real estate preferred shares. On a negative note, one thing that worries me about this fund is the credit quality breakdown of its holdings. The majority of the fund's holdings are rated either BBB- to BBB+ or BB- to BB+. One reason for this is because it's very rare for preferred stocks to have an AA or above rating because preferred stocks have a lower priority over a company's bonds in the event of a liquidity. So even if a company's corporate bonds had an AAA+ rating, its preferred shares could still have a lower rating because these ratings are determined by the probability of getting paid and bonds have a higher probability of getting paid since they have a higher priority. Once all bonds are paid off, if there is still money left, it will go to preferred shares but not before that which makes them riskier than bonds. Then again, if you think that companies like JPMorgan are going bankrupt anytime soon, maybe you should be in US treasuries rather than either common or preferred stocks.

The fund has been paying its dividends on monthly basis since its inception and it never missed a dividend distribution but also keep in mind that there won't be much of a dividend growth with this fund since most of its holdings are on fixed rate. In total less than 5% of the fund's holdings are on floating rate which makes its dividends pretty stable from year to year.

One thing I like about this fund is its low fee. The fund's total expense fee is only 0.23% as compared to its peers whose expense ratios range from 0.41% to 0.85% which can eat into your distributions over time especially considering that preferred shares have limited growth both in terms of share price and dividend distributions.

I must add one thing though. While preferred shares have (almost) no share price appreciation, there are rare periods where they trade significantly below their par value and they pose an upside potential during those times. Currently the fund trades about 20-25% below its on par value ($25 per share) so there is actually an upside potential but we don't know when it will be realized. It could be realized next year or 10 years from now. Sooner or later it will go back to its par value (unless something really breaks), we just don't know when.

There are two risk factors associated with this fund. First, inflation could make a comeback and force the Fed's hand into a more aggressive stance like how it did in 1980s. If this happened, preferred shares would lose a lot of value but this appears to be an unlikely event at the moment. Second, if we have a deep recession where financial companies are in trouble (like they were in 2008) a possible bankruptcy of one major bank could trigger an event where all financial preferred stocks take a dive. In 2008, we saw some preferred stocks drop as much as 90% at one point so these are not totally risk free instruments. Earlier this year we saw several small and regional banks get in trouble but so far big banks seem to be doing fine. Then again, these things could change without much notice. No one expected regional banks holding US treasuries to fail until after it happened because treasuries were considered "risk free" but there is no such thing as risk-free when you are leveraged, as those banks found out. Big banks are also leveraged but in a different way so you never know.

All in all, I like this fund's chances and buying it in small amounts. You can too as long as you keep your expectations in check and have realistic expectations in terms of dividend growth and share price growth.

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