PFF - VRP Vs. PFF: Choice Comes Down To Outlook On Rates

2023-09-05 05:42:07 ET

Summary

• iShares Preferred and Income Securities ETF is the dominant preferred ETF with over $12.76 billion in assets under management.
• The Invesco Variable Rate Preferred ETF could be getting more attention due to its floating rate exposure that shows less sensitivity to rising interest rates.
• Both had seen their yields start to rise, but some of those gains for PFF have been reversing more recently, while VRP's payout has continued to rise.

Written by Nick Ackerman, co-produced by Stanford Chemist.

iShares Preferred and Income Securities ETF ( PFF ) is the dominant preferred ETF with assets under management of over $12.76 billion. It's a passively managed fund with its benchmark, the ICE Exchange-Listed Preferred & Hybrid Securities Index. This is often the go-to ETF to benchmark other preferred investments against to see how they performed, as PFF is directly investible.

However, one fund that could certainly be getting more attention due to rising rates would be the Invesco Variable Rate Preferred ETF ( VRP ). This would be thanks to its floating rate exposure that should be benefiting as interest rates are increased. This fund is also passively managed based on the ICE Variable Rate Preferred & Hybrid Securities Index.

AUM And Performance Comparison

For now, VRP is dwarfed by PFF with only around $1.5 billion in assets being managed - although, quite a respectable size nonetheless. Both funds have been struggling with returns in this environment, and the banking crisis impacted both funds earlier this year as they both are heavily exposed to financials. That being said, VRP has managed to keep AUM mostly flat in the last three years while PFF is down quite considerably. Of course, the future is anyone's guess, but should this trend continue, then eventually, VRP will become the larger fund.

Over the long term, or at least going back to VRP's inception on May 1st, 2014, VRP has been the winner. That being said, we can clearly see these funds were heavily correlated while rates through this period were mostly at 0%.

It was more in the last year or so there was significant divergence. Of course, this is when interest rates began to climb rapidly higher as the Fed was aggressively looking to slow the economy to get inflation under control. So

with that, we can look at the performance between now and January 1st, 2022, to give this period a closer look. As we can see, neither fund performed particularly well, but it was VRP that was able to hold up relatively better and keep losses more limited.

We can also see above that both funds did experience a sharp drop in returns right around the banking crisis in 2023 - just as both were starting to make some recovery from last year's losses.

Portfolio Positioning

The divergence we see above would come down primarily to portfolio positioning. While they are both passively managed funds, they benchmark against quite different indexes. VRP's effective duration comes to 1.88 years, and its modified duration is 2.15 years. This is quite low and reflects the fund being relatively limited in terms of its interest rate sensitivity.

Unfortunately, I couldn't find PFF's duration listed. Some other preferred funds with no focus on variable rate securities have durations closer to 4 years or higher. That includes the First Trust Preferred Securities and Income ETF ( FPE ), with a duration of 3.9 years. VRP's sister fund, Invesco Preferred ETF ( PGX ), comes in with a duration of 5.82 years.

So, from this small sample of looking at peers, it could suggest that VRP is relatively less interest rate sensitive as it carries a lower duration. That's also supported by the fact that it was the best-performing fund during the 2022 to date period. Therefore, investors thinking that the Fed is going to ramp up rates even higher than they are now but still want preferred exposure could benefit from investing in VRP.

However, it should be noted that even with what should appear to be vastly different portfolios, they actually share some overlap too. This includes significant overlap in terms of the credit quality of their underlying portfolios. Both portfolios run with around half of their holdings rated at investment-grade. That should help, at least relative to a more junk-oriented portfolio, when the economy slows and if we start to see higher defaults.

For PFF, just over 52% of their portfolio is invested in what's considered investment grade ratings of BBB or higher.

For VRP, it's more or less quite similar, with around 57% being at BBB. However, VRP carries a fairly small portion of securities that would be considered not rated relative to PFF.

In looking at each fund's sector allocation, we can see the dominant sector is financials. This is because financials are one of the largest issuers of preferreds due to help keep them within their regulatory capital ratios. These are going to overwhelmingly be non-cumulative perpetual preferred securities for that reason, as those are the only ones that count for what banks are trying to achieve in their capital ratios.

Given these types of sector weightings, it's really no surprise as to what we see when we look at the top ten of each fund. It's where we really start to see the overlap come into play in terms of company exposure, where both reflect heavy exposure to the largest banks of Wells Fargo ( WFC ), Citigroup ( C ), Bank of America ( BAC ) and JPMorgan ( JPM ).

Both have WFC as their largest position. However, for VRP, they hold the Series BB with its 3.9% coupon as its largest holding. As of their last semi-annual report, they also held WFC's Series S 5.9% and Series U 5.88%.

For PFF, it is WFC's Series L 7.5%. PFF also holds the Series AA with its 4.7% coupon, the Series CC with a 4.38% yield, the Series DD 4.25%, the Series Q and Series R, which are now floating at 5.85% and 6.63%, respectively, at the end of their last annual report . Since that report, on August 10th, 2023, Wells Fargo announced that they would be redeeming all of their Series Q preferred. This is one reason why it can be difficult for a fund to actually run with a variable rate portfolio because when they start to float, they are often redeemed. They also carried the Series Y 5.63% and Series Z 4.75% at the end of their fiscal year as well.

A Look At The Dividends

One important factor for investing in preferred funds is the dividends. These are income-oriented securities, after all. Fortunately for investors, both pay on a monthly schedule to pass along their cash flows to investors more regularly.

We can give PFF a look first. The fund currently has its 30-day SEC yield listed as 6.56% and its 12-month trailing yield at 6.78%. Based on the last annualized payout, the yield comes to 6.25%. The fund had seen its dividend start to trend higher through 2022 as rates started heading higher. However, interestingly, the trend started to reverse and head lower.

Looking at a dividend table might give us a better look at what's going on over this period of time. As we can confirm, it would appear that the dividend was slowly trending lower before we saw that reversal in 2022.

This is actually quite expected, as preferred securities share the same characteristic of debt in terms of being at the mercy of rates and yields. Over this period of time, rates were pegged at or close to 0%, and as older securities matured, there were lower-yielding instruments to invest in.

That's why despite what was a mostly flat share price on PFF through this period, the year-end yield went lower and lower. Of course, the big drop in share price last year also helped propel the year-end yield higher, but we can see there was finally some growth in the total annual payout as well.

For VRP, we don't have quite as long of a history, so it's harder to provide a direct comparison. That being said, we can clearly see that the dividends have been increasing for VRP over the last year and a half or so. They didn't experience the reverse in the last several months, such as we saw with PFF.

That being said, its yield figures actually come in lower relative to PFF. The 30-day SEC yield for VRP comes to 5.63%, with the 12-month trailing rate at 5.82%. However, based on the last dividend paid out, we would see its yield climb to 6.57% to compete against PFF now.

Over the years, VRP showed a somewhat similar trajectory as PFF. Again though, shorter history gives us less to work with in terms of trying to provide a better comparison between the two. Overall, the yield had been mostly trending flat or heading lower before 2022.

Conclusion

PFF is the most popular preferred ETF on the market. However, VRP should be a consideration for investors that expect the Fed to remain raising interest rates. Both can see increased dividends over time with higher rates, but VRP should be able to experience that a bit quicker with its higher focus on floating-rate securities. Of course, one of the problems with that is banks redeeming their floating rate exposure shortly after they begin floating. We've already seen the benefit of lower losses for VRP in this rising rate environment.

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