PFFR - PFFR: REIT Preferred ETF Strong Stable 8.1% Yield

2023-07-05 23:05:01 ET

Summary

• PFFR offers investors exposure to REIT preferred.
• It offers investors a strong 8.1% dividend yield but is less diversified than most of its peers.
• The fund's strong yield makes it a buy, but the fund's niche holdings mean positions should be kept small.

Author's note: This article was released to CEF/ETF Income Laboratory members on June 18th.

The InfraCap REIT Preferred ETF (PFFR) offers investors exposure to REIT preferred, and has a strong, stable 8.1% dividend yield. PFFR focuses on a specific investment niche, providing less diversification than most preferred or bond index ETFs. In my opinion, the fund's strong yield makes it a buy, but the fund's niche holdings mean positions should be kept small.

PFFR - Overview and Analysis

PFFR is a preferred shares index ETF. The largest ETF for these securities is the iShares Preferred and Income Securities ETF ( PFF ), which shares many similarities and differences with PFFR. I'll be comparing these two funds throughout the article, as doing so will help show PFFR's most important characteristics, positives, and benefits.

Index and Holdings

PFFR is a REIT preferred index ETF, tracking the Indxx REIT Preferred Stock Index . It is a relatively simple index, investing in all U.S. REIT preferred shares meeting a basic set of inclusion criteria, including having a yield greater than 3.0%. At current interest rates, said criteria does not materially limit the fund, although the impact was much greater in prior years. It is a market-cap weighted index, with certain rules to ensure a modicum of diversification, which is particularly important considering the index's niche holdings.

PFFR exclusively invests in REIT preferred, while most other preferred ETFs, including PFF, invest in preferred from most industries. The result is a somewhat concentrated fund, focusing on an incredibly narrow industry niche. It does have quite a bit of diversification within said niche, with investments in 105 different securities from 50 different issuers. PFFR's largest holdings are as follows.

As a comparison, PFF invests in over 400 securities from hundreds of issuers, and with exposure to three different industries.

PFFR's greater concentration increases risk, volatility, and the potential for outsized losses and underperformance due to losses in any one specific issuer. As an example, and as per fund data, PFFR has seen losses of around 4.0% due to weakness in Vornado Realty Trust ( VNO ), an office REIT. Very sizable losses from an individual issuer, and VNO is still alive and profitable .

Losses in other office REITs, including Diversified Healthcare Trust ( DHC ) and Hudson Pacific Properties ( HPP ), amount to another 4.0%. These losses have been almost entirely responsible for the fund's underperformance since inception.

PFFR's concentrated portfolio is a significant negative for the fund and its shareholders. As such, and in my opinion, investors should limit position sizes in the fund, so as to avoid the possibility of significant underperformance due to idiosyncratic factors. I would not go above 5%.

Dividends

PFFR offers investors an 8.1% dividend yield. It is a strong yield on an absolute basis, moderately higher than PFF's 6.3% yield, and higher than that of most types of bonds and equities.

PFFR's dividends are remarkably stable too, with the fund paying the exact same $0.12 monthly dividend since early 2019. Dividends fluctuated in prior years, especially when the fund changed from a quarterly dividend to a monthly one in early 2019, but these were not dividend cuts per se.

PFFR's dividend stability is an important benefit for shareholders, especially considering the fund's strong yield.

On a more negative note, the fund's dividends are looking a bit unsafe, a bit risky, right now, for two reasons.

First, the fund's underlying holdings generated around 0.40% less in income than the fund distributed to shareholders in May. As per my own calculations using fund data , a similar gap remains as of June.

As the fund's dividends are not fully covered, these could very easily be cut in the coming months.

Second risk for the fund's dividends is ongoing office REIT weakness. Demand for offices is quite weak, as more and more workers are choosing to work from home over commuting to an office. Higher interest rates also negative impact heavily indebted REITs although, from what I've seen, the riskier, more leveraged REITs have hedged their interest rate exposure. In any case, continued sector weakness could result in dividend suspensions. From looking at PFFR's major holdings, it seems that office REITs account for around 10% of the value of the fund, so the fund could see sizable reductions in income and dividends if this were to occur.

PFF's dividends seem much safer than those of PFFR, in these regards.

On a more positive note, the fund will almost certainly benefit from higher interest rates from previous Fed hikes. It can take years for hikes to pass through to all relevant securities, including preferred, and months for ETFs to distribute increased income to shareholders, but it should happen. For what it's worth, PFF has seen strong dividend growth since hikes started in early 2022, as have most other broad-based bond index ETFs.

Performance Track-Record

PFFR's overall performance track-record is below-average, at best, with the fund underperforming relative to PFF, and most broad-based bond index ETFs, since inception.

PFFR's underperformance was mostly due to weakness in the office REIT sector, as mentioned previously.

From what I've seen, widening credit spreads also played a role, as PFFR tended to underperform relative to PFF when credit spreads narrowed, outperformed when these widened. Specifically, PFFR outperformed from inception to very early 2020, when credit spreads were low and stable / narrowing. The fund significantly underperformed when spreads widened as the coronavirus pandemic was in full swing, from February 2020 to late 2020. PFFR matched the performance of PFF in 2021, when spreads slightly narrowed, and then significantly underperformed from 2022 onwards, when these widened.

Credit spreads, influenced by underlying economic conditions and investor sentiment, seem to play an important role in PFFR's absolute and relative performance.

Conclusion

PFFR's strong 8.1% dividend yield makes the fund a buy. As the fund is quite concentrated, position sizes should be kept small, in my opinion at least.

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