PFFV - PFFV: Variable Rate Preferred ETF 6.5% Yield Some Rate Risk

2023-04-18 06:48:36 ET

Summary

• Rates are rising.
• Variable rate funds tend to offer strong, growing yields with little interest rate risk.
• PFFV is a variable rate fund, but with more rate risk than expected.
• An overview of the fund follows.

I've covered several senior loan ETFs in the recent past, as these funds tend to sport strong yields, and tend to outperform when rates rise. Notwithstanding these benefits, I've generally been lukewarm about these funds, due to their high expense ratios. I've been trying to find a cheaper alternative to these funds for a while. I thought the Global X Variable Rate Preferred ETF ( PFFV ), investing in variable rate preferred and with a low 0.25% expense ratio, might work, but that does not seem to be the case.

PFFV is technically a variable rate fund but, in practice, behaves like a fixed-rate fund, as the fund's holdings generally take years to reset their rates. Although there is nothing inherently wrong with this, it does mean that the fund offers few benefits relative to fixed-rate high-yield corporate bond fund, and that the fund does have some interest rate risk. As such, and in my opinion, PFFV is a reasonable investment, although nothing special.

Quick Variable Rate preferred Overview

PFFV invests in variable rate preferred. As this is something of a niche sub-asset class, thought to do a quick overview of these before looking at the fund itself.

preferred shares are a hybrid asset class, with characteristics of both bonds and equities. PFFV's preferred are, however, much closer to bonds, especially high-yield corporate bonds, than to equity.

Variable rate preferred have differing interest rate / interest payment policies. Most pay a fixed rate of interest for a few years at first, and then a variable rate. Said variable rate is almost always a specified benchmark rate, say the Fed funds rate or a treasury rate, plus a spread. As an example, most Goldman Sachs ( GS ) preferred, the fund's largest issuer, pay 3.0% - 6.0% for the first few years after issuance, and then pay 5Y treasury rates plus 2.5% - 4.0%.

Variable rate preferred have different benchmark rates, but most of these are at least indirectly tied to Federal Reserve rates. Higher Fed rates means higher benchmark rates which means higher variable rate preferred rates. The relationship is somewhat indirect, and the process is not immediate.

preferred are senior to common shares, but junior to bonds. Due to this, their overall risk profile is somewhere between that of these two asset classes. Non-investment grade bonds are somewhat similar. Senior loans are closest to variable rate preferred, due to their comparable level of credit risk, and variable rate of interest.

With the above in mind, let's have a look at PFFV.

PFFV - Overview

PFFV is a variable rate preferred ETF, tracking the ICE U.S. Variable Rate preferred Securities Index . Said index includes most relevant securities in its sub-asset class, subject to a basic set of inclusion criteria. It is a market-cap weighted index, with issuer weights meant to ensure a modicum of diversification.

PFFV targets a niche sub-asset class, which results in a very targeted fund with only a small / moderate amount of diversification. I'm counting 43 issuers, a relatively low number. The fund focuses on financials, which tend to issue preferreds with higher frequency than other industries.

Concentration is above-average, with the fund's top ten holdings accounting for over 50% of its portfolio. In my opinion, PFFV is not diversified enough to function as a core portfolio holding, or for a significant investment. It is not terribly risky, but I do think more diversification is required.

PFFV's credit quality is reasonably good, if somewhat below-average. Credit ratings go from B- to AA+, but most are between BB and BBB. So, either barely investment-grade, or barely non-investment grade. As a comparison, most broad-based bond funds focus on investment-grade bonds, while most high-yield corporate bond / senior loan funds exclusively invest in non-investment grade. PFFV's overall credit quality would be somewhere between these two types of funds.

Riskier fixed-income securities tend to have higher yields. PFFV's credit quality is below-average, which should result in an above-average yield, as is indeed the case. The fund currently sports a 6.5% dividend yield, highest in its peer group. On a slightly more negative note, the fund's latest SEC yield, is a bit lower than those of high-yield corporate bonds and senior loans. These two sub-asset classes have even lower credit quality, hence the lower yields.

PFFV's dividend growth track-record is quite weak, with dividend's growing a meager 2.2% these past twelve months. Growth has been much lower than expected for a variable rate fund too. Growth has been weak for two reasons.

First, is the fact that many of the fund's underlying holdings are recent issues, and so are still paying fixed rates of interest. Some of these are seeing their rates reset right now, some will see higher rates in the coming months, others in the coming years . Lots of companies took advantage of historically low interest rates in 2020-2021 to issue lots of debt at very favorable terms, and it seems preferred shares issuers did too.

Second reason for the fund's weak dividend growth track-record has to do with its distribution policy.

PFFV's dividends are remarkably stable, oscillating between $0.12 and $0.125 per share per month since inception. Graph below, pay attention to the key on the right.

PFFV's yield was a bit higher than expected in early 2022, before the Fed started hiking. As per my calculations, the fund was yielding 5.0% - 5.5% at the time, even though yields for BB - BBB rated bonds, fund's closest analogue, were quite a bit lower.

Some ETFs try to maintain stable dividends, as is obviously the case for PFFV. The fund accomplished this by paying higher than expected dividends in early 2022, but lower than expected dividends these past few months. The stability itself is something of a positive for investors, even though it does mean that dividend growth figures look mediocre. Considering recent Fed hikes, and the fund's 6.8% SEC yield, I think future growth is much likelier. As the fund does try to maintain stable dividends, growth could take a longer to materialize than expected. Due bear in mind, the fund's underlying holdings have seen their interest rates increase, and PFFV's investors do benefit from this, even if dividends do not technically increase.

Variable rate fixed-income securities tend to benefit from higher rates, while fixed-rate securities see lower prices when rates rise. Due to this, variable rate securities tend to outperform during periods of rising interest rates. Depending on the specific time period analyzed, I'm seeing either a tiny bit of outperformance for PFFV or none at all. Significant outperformance has not occurred. Senior loans performed much better, and much more in-line with expectations.

PFFV's performance was much weaker than expected, as many of the fund's underlying holdings are currently paying a fixed rate of interest. Rates do reset, sooner or later, but as long as that is not the case PFFV will perform like a fixed-rate fund. This was the case in 2022, and is generally the case for the fund.

In my opinion, the above severely undercuts the fund's investment thesis. Variable rate funds and investments are supposed to perform well during periods of rising rates. This has not been the case for PFFV in the past, and, unless the fund's portfolio undergoes drastic changes, will not be the case in the future.

PFFV's underlying holdings should see higher interest rates sooner or later, they are variable rate preferreds after all, but most bond funds do too, from cycling their portfolio as their bonds mature. PFFV offers few advantages relative to its peers in this regard.

Quick Senior Loan Comparison

PFFV is most similar to senior loan funds, so thought to do a quick comparison between the fund and these securities.

Both sub-asset classes focus on variable rate securities.

Senior loans are effectively always non-investment grade securities. PFFV's credit ratings are a bit higher, with investments in AA-BBB rated securities. preferreds are junior to bonds, however.

Both sub-asset classes offer above-average yields. Senior loan yields are generally a bit higher, however.

Both sub-asset classes outperform when interest rates are rising. Senior loans outperform significantly more, however.

PFFV's 0.25% expense ratio is about average for a niche index fund, but much lower than that of most senior loan ETFs. As an example, the SPDR Blackstone / GSO Senior Loan ETF ( SRLN ) has an expense ratio of 0.70%, while the Invesco Senior Loan ETF ( BKLN ) has a ratio of 0.65%. As per Global X, PFFV's expense ratio is 50.0% lower than its peers.

In general terms, I think both securities are reasonable, but I was a bit disappointed with PFFV's recent performance. I expected something much closer, but cheaper, to a senior loan fund, but the interest rate risk is much greater. The overall value proposition of senior loans seems stronger, although much will depend on the specific requirements and goals of each individual investor.

Conclusion

PFFV is a reasonable investment, but with few advantages relative to peers. As such, I see no reason to pick PFFV over its peers.

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