PFFA: Preferred Stock ETF Characterized By High Yield And High Risk

Virtus InfraCap U.S. Preferred Stock ETF

Virtus InfraCap U.S. Preferred Stock ETF (NYSEARCA:PFFA) is an exchange traded fund (“ETF”) launched and managed by Virtus ETF Advisers LLC. It is co-managed by Infrastructure Capital Advisors, LLC (“ICA”). ICA is a registered investment advisor that manages 15 funds, including an actively managed ETF and a series of hedge funds. The firm was formed in 2012 and is based in New York City. Currently, Virtus has an asset under management (“AUM”) of $1.29 billion.

Virtus InfraCap U.S. Preferred Stock ETF was formed on May 15, 2018 (almost four years back) and is domiciled in the United States. The fund has an AUM of less than $500 million, which it invests in fixed income markets, primarily in preference shares of United States-based infrastructure-related companies. As a result, it generates a steady level of current income. It invests directly and through derivatives such as options. The fund seeks to benchmark itself against the S&P U.S. Preferred Stock Index.

Preferred Securities – Is It Better Than Common Equities and Bond

Preference shareholders enjoy a priority in the time of dividend payment over common equity holders. They also have a preference over the organization’s assets in the event of a liquidation. Like bonds, preference shares provide investors with current income through dividends, which may be either at a fixed rate or a floating rate. Preference shares also generally generate a higher yield than the equity shares. Preferred dividends, in certain cases, are taxed at a lower rate for corporations. Dividends received by C-corporations may be tax deductible when it is received from related entities.

For investors, preference shares have behaved more like bonds, as they often carry a rating from a credit rating agency. At the same time, like common equity shares, preference shares are issued to retail investors and are traded on major stock exchanges. However, these stocks generally exhibit less volatility. Collectively, the market for preference shares has become four times since 2005 and is approximately valued at $1 trillion. But, despite market growth, preferred securities are often ignored by traditional investors.

Preference shares are less risky than equity shares as all payments to preferreds are made before any payments to common equity holders. However, in case of loss, preferred dividends may get deferred or suspended, while interest payments to bondholders will continue as usual. Hybrid nature of preferred shares makes it a little unattractive for investors.

According to materials published on Virtus website:

“Given this deferral risk, the market is largely focused on investment grade companies, where cash flow is more stable and probability of default is lower……With interest rates moving higher, investors may be concerned about the potential impact on the price and yield of preferreds. However, various features of these securities can help moderate their sensitivity to changes in interest rates.”

Most preference shares are issued under fixed-to-floating convertible pay-out option. According to materials published on Virtus website:

“a security may be issued with fixed coupons for a pre-set number of years, commonly five or 10 years, and then converted to a floating rate coupon………The moving rate is set with a spread to a certain benchmark interest rate index for the remaining life of the security or until it is called.”

Composition of PFFA’s Portfolio & its Benchmark Index

Virtus InfraCap U.S. Preferred Stock ETF has invested its fund in over 150 preferred stocks, that includes preference shares of numerous unlisted companies. However, they are known for paying strong and steady dividends. Almost 60 percent of the entire fund is invested in preference shares of 20 companies such as Crestwood Equity Partners LP (CEQP), RLJ Lodging Trust (RLJ), DCP Midstream, LP (DCP), Babcock & Wilcox Enterprises, Inc. (BW), The Necessity Retail REIT, Inc. (RTL), NuStar Energy L.P. (NS), DigitalBridge Group, Inc. (DBRG), EPR Properties (EPR), New York Mortgage Trust, Inc. (NYMT), etc.

PFFA’s stated benchmark index, the S&P U.S. Preferred Stock Index, measures performance of the U.S. preferred stock market. According to materials published on Virtus website:

“The index is calculated on a total return basis with dividend reinvested. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and is not available for direct investment.”

However, PFFA has a very high expense ratio of 1.2 percent. This might make investment in Virtus InfraCap U.S. Preferred Stock ETF unattractive to a certain degree.

Risk and Rewards of Investing in Preferred stocks

As Virtus InfraCap U.S. Preferred Stock ETF invests in preferred stocks, it is able to generate a steady current income in the form of dividend. The fund is paying a steady monthly dividend. The current monthly payout is 0.1625 per share. During the past four years, this ETF has generated an average yield of almost 9 percent. On the back of such high yield, the fund has been able to generate a total return in excess of 8 percent over the past four years. However, 2022 has been poor in terms of return, as there is a price loss of almost 15 percent, and the total return has been negative.

Preferreds are an effective tool in strategic asset allocation. However, creating a portfolio of preferred stock is not an easy task, as these stocks are not highly traded. According to materials published in Virtus website, while investing in a portfolio consisting of preference stocks, the fund manager at ICA had to:

“evaluate the potential investment options on a variety of key variables, including the competitive position of a company; the perceived ability of the company to earn a high return on capital; the historical and projected stability and reliability of the profits of the company; the anticipated ability of the company to generate cash in excess of its growth needs; and the access of the company to additional capital.”

In addition to that, the fund manager at ICA applied leverage to potentially enhance the portfolio exposure, and employed option strategies in order to generate additional current income. Opportunistic short positions are also employed to hedge interest rate risk. However, short positions enhance the risk of the portfolio. Also, when a portfolio is leveraged, the value of its securities becomes more volatile. A 40-year-high inflation, rising interest rates, shortage of supplies in the energy market, looming recession, and geopolitical turbulence make this portfolio further risky.

Investment Thesis

Investors may consider preference shares as an income hybrid with the potential to diversify their fixed income portfolios, achieve an attractive dividend yield, and manage interest rate risk in an environment of expected rate hikes – all in all, a good tool to have in a strategic asset allocation. During the past four years, on the back of a high yield, the fund has been able to generate a total return in excess of 8 percent. The fund so far has paid a steady monthly dividend. Thus, it’s not a bad option for the income-seeking investors.

However, preference shares involve deferral risk when it comes to dividend income. With interest rates moving higher, investors may also be concerned about the potential impact on the price and yield of preferreds. Moreover, the short positions may increase the risk of the portfolio. The leveraged factor may also make the portfolio more volatile. On top of that, excessively high inflation, supply side shortages in the energy market, and looming recession make Virtus InfraCap U.S. Preferred Stock ETF a risky proposition.