2023-03-16 04:51:12 ET
Summary
- The iShares Preferred and Income Securities ETF is an exchange-traded fund that invests primarily in preferred stocks.
- The vehicle represents a granular, diversified portfolio of banks' and industrial companies' preferred equities.
- Some of the bank names making the headlines are present in the PFF portfolio, but with a very low weighting given its granularity.
- The fund currently offers yields in excess of 6% without any single issuer concentration issues.
- Given the binary outcome for certain preferred shares (i.e. full wipe-out during a default), a retail investor is best served to shy away from single issuer risk.
Thesis
The iShares Preferred and Income Securities ETF ( PFF ) is an exchange-traded fund that invests primarily in preferred stocks and other income-producing securities. The fund represents a diversified take on financials preferred equities and is the correct way to evade single issuer concentration issues in a distressed market like today's.
As we have seen from the Silicon Valley Bank ( SIVB ) and Signature Bank ( SBNY ) bankruptcies, preferred equities can lose all their subordination quite fast in bank run. As a reminder, we have penciled in zero recoveries for both series of preferred securities, given where the senior unsecured notes are trading. As a reminder preferred stocks are a type of equity security that pays a fixed dividend and has a higher priority over common stocks in terms of receiving payments in the event of a company's bankruptcy, but in the case of bank runs they get wiped out fairly fast as well.
The issue with sudden bankruptcies lies with the distressed liquidation value of many assets. Let us take Signature Bank for example, which did not have a very large available for sale ((AFS)) or held to maturity ((HTM)) portfolios. What Signature does have is a large CRE loans portfolio. According to Trepp, Signature was one of the top 10 CRE lenders in the country. Even if all of these loans are money good (i.e. 100% recovery), if the estate tries to sell them now it is going to get bids in the 80s most likely. Why? Because rates are much higher and people are shunning risk.
PFF overcomes single issuer concentration problems by having a large diversified portfolio:
What this financial crisis has shown us is that management cannot be trusted for some regional banks. There will be official enquiries here but SVB's management seems to have been very poor , to put it lightly, while it just came out that SBNY was potentially facing a criminal probe before its collapse, and the FDIC did not trust its management:
“The bank failed to provide reliable and consistent data, creating a significant crisis of confidence in the bank’s leadership,” the state’s Department of Financial Services said in an emailed statement Tuesday. “The decision to take possession of the bank and hand it over to the FDIC was based on the current status of the bank and its ability to do business in a safe and sound manner on Monday.”
How do you hedge yourself against such management teams? By simply diversifying away. PFF does that for you via its granular portfolio, while at the same time still clipping a healthy yield.
Holdings
The fund has a large portfolio of preferred securities, mainly from the financial services industry:
From a credit quality perspective the fund is overweight investment grade names, but that has proven to hold little value in today's crisis:
The fund does contain many of the names currently experiencing issues, but because it runs a diversified portfolio, the weightings are very small for each issuer:
Even if all the banks in the news do end up defaulting, the fund is going to be all-right because their combined weighting is no higher than 1.5% of the notional. More importantly, given the fund marks to market daily, most of the move has already been embedded in the lower pricing, thus only a limited impact will ensure.
The largest holdings in the fund currently are large, extremely safe institutions:
Top Holdings (Fund Fact Sheet)
The top holding here is sub 2% of the portfolio, and is represented by a systemically important institution, namely Wells Fargo (WFC).
Performance
The fund has a robust long term performance, but it is a cyclical vehicle:
We can see massive drawdown during Covid, and most recently in 2022 as rates began to rise. Given the current financial crisis and higher rates, one would argue starting to layer into this fund is a good historic opportunity.
You do not want to buy into PFF when default rates are low and we are in a bull market. You want to get in when there is 'blood on the streets' and investors are expecting more banks to default. We have that type of situation right now.
Conclusion
PFF is a fixed income exchange traded fund. The vehicle focuses on preferred equity with an overweight allocation to bank preferred securities. The fund does contain some of the names which are currently in the news, with a default of all respective issuers resulting in only a 1.5% hit to the PFF portfolio. With over 480 issuers in the portfolio and a maximum concentration of 2% per name, the fund represents a diversified take on preferred equity. Given potential single issuer bankruptcy and complexity of banking operations, the best way for a retail investor to take advantage of the current banking crisis is by shunning single name preferred shares and buying into a well-diversified vehicle such as PFF. The fund is cyclical, with substantial drawdowns during periods of stress. We believe we are currently experiencing such a period, hence today's environment is a good one to start accumulating a position in this fund.
For further details see:
PFF: A Right Way To Trade The Regional Banking Crisis