2023-11-01 10:52:42 ET
Summary
- Virtus InfraCap U.S. Preferred Stock ETF is an actively-managed ETF that holds preferred stocks from across the US investible universe.
- PFFA has outperformed its benchmark substantially since its inception.
- Preferred stocks are attractive due to the relative strength in corporate debt and a significant divergence from par value.
Introduction
Many income investors, especially those who only have expertise in the world of equities, often find themselves mystified by the world of preferred shares. They are the gray area of equities where they can offer the upsides and downsides of equities (at least partially), but also have characteristics of fixed income. In the last ten years, many of these shares could have been written off as low interest rates kept their yields down. Now that things have changed and rates and the Fed Funds Rate is at 5.33% , preferred stocks have been given some new life and are looking far more attractive than they have in some time.
Allow me to introduce the Virtus InfraCap U.S. Preferred Stock ETF ( PFFA ), an actively managed ETF that holds preferred stocks from across the US investible universe, across all market caps above $100M, and across all credit ratings. This diversity allows for a very interesting dynamic in the fund, which has caused it to outperform its benchmark substantially since its inception.
See here for a good refresher on the basics of preferred shares . Otherwise, skip on to the next section.
Brief Overview
- Name : Virtus InfraCap U.S. Preferred Stock ETF
- Price : $18.04
- Dividend Yield : 10.68%
- Dividend Per Share : $1.8406
- Volatility : 14.45%
- Beta : 0.34
- Trading Volume (30-day) : 2,733,601.20
- Expense Ratio : 1.40%
- AUM : $592,286,425
Sector Exposures :
- Real Estate 26.89%
- REITs (Mortgage) 18.87%
- Industrials 13.72%
- Energy 11.49%
- Financials 11.44%
The Fund seeks current income and, secondarily, capital appreciation through a portfolio of preferred securities issued by U.S. companies with market capitalizations of over $100 million. Security selection and weightings are based on a variety of quantitative, qualitative, and relative valuation factors. Modest leverage (typically 20-30%) is utilized to help enhance portfolio beta and current income.
Below, Figure 1 shows PFFA's total return over the last five years compared to its benchmark passive index.
Figure 2, below, shows dividend yield. Note that since 2022, the yield has been steadily raising. We should expect the yield to follow declines in price as PFFA moves further from its par value.
Returning to Par
This follows as an inverse to the price, since most preferred stock are at fixed rates relative to their par value. In this case, PFFA's "par" more or less, is $25. This represents the ceiling of the fund's price, since that is the value that would be paid to investors if all the stock was called and settled into cash. Of course, premium and discount gaps between price and NAV occur in ETFs, in any asset with uncertain yields, and with lesser-traded and less liquid ETFs. This does mean that while it could trade over $25, it's unlikely to for a long amount of time.
PFFA's NAV is currently 28% below this theoretical par value. Figure 3 below shows PFFA's NAV over the last several years.
This trade, and the buy rating I'm giving PFFA, hinge primarily on this discount from NAV being as wide as it is. 2022 and most of 2023 left preferred stock heavily discounted, perfect for adding some substantial yield to a portfolio with potential for price appreciation. The yield on preferred stock offers investors a nice cushion and price floor, since they are paid out before common shareholders in dividend and distribution events. This discount from par provides for further cushion to investors as it leaves significant upside room if these shares return to par.
According to Virtus , PFFA's current unrealized loss on its holdings amounts to ($119,117,940.81). This loss is less than the stock's price decline, signalling that the market is pricing in significant levels of credit risk.
Credit Risk
Nothing comes without risk, and the preferred stock's most major risk is credit risk. In the event of a corporate default, bondholders and creditors are paid first, then preferred shares get to pillage what's left, and common stockholders are often left with absolutely nothing. This is credit risk.
To this end, PFFA's sudadviser, InfraCap , weights stocks in the fund based on their proprietary quantitative, qualitative, and relative valuation models.
Beyond the active selection and screening process done by the advisers, it's important to note the macroeconomic conditions of corporate debt. Figure 5 shows us the overall decline, but short-term uptick in, business loan delinquencies. As floating rate debt rises to match overall rising interest rates, we should expect to see this kind of pain coming to the market. Interestingly enough, we still see a lower delinquency rate today than two years ago.
This risk is not to be understated, however. It is critical for conservative investors to note that the substantial yield does come with its downsides. Preferred shares have more beta than most fixed income products, and the fund's leverage may introduce more risk than investors initially signed up for.
Currently, that leverage is at 29%, but could change moving forward. This leverage is the exact reason the fund reacted so poorly to a catastrophic credit event like the March 2020 crash, as seen in Figure 1. Beware of the added beta that the fund's leverage brings.
Allocation
Preferred shares are best allocated to via actively managed funds, as quality selection is very important to overall returns, as noted in Figure 1. The passive index does not capture the greatest returns as they do not screen for negative yield-to-call ratios and other quality factors.
For a traditional fixed income portfolio, I would allocate no more than 10% to preferred shares. As a diversifier for an equity-heavy portfolio, aggressive investors could likely afford upwards of a 20-25% allocation.
Conclusion
PFFA's shares are attractive due to two major reasons: relative strength in corporate debt (though something to watch moving forward if rates are indeed "higher for longer" ) and a massive 28% divergence from par value, shown by Figure 3.
Moving forward, we should expect a margin of safety provided by the large 10% yield and its significant discount to par. I expect the yield to hold steady so long as rates are not raised (the Fed projects this to be the case , currently). This trade make take some time to play out, so investors may expect this divergence from NAV to last at least through the end of this year.
For further details see:
PFFA: Buy This Preferred Stock ETF Trading At A Discount