PFF: The Preferred Choice For Income Now And Capital Appreciation Potential Later

iShares Preferred and Income Securities ETF (NASDAQ:PFF) offers investors exposure to US preferred stocks. Preferred stocks have bond-like characteristics and pay high dividends. PFF currently has a 30-day SEC yield of about 6.6%. The main goal of PFF is to provide high income to investors that are competitive with the yield of junk bonds. The vast majority of this ETF’s approximately $13B AUM is in preferred stocks in the financial sector. Financial stocks took a big hit in 2023, but I think the short-lived banking crisis is over. For income investors, I think PFF is a relatively safe investment to get high yields now and capital appreciation in the future. Because of this, I rate PFF a Buy.

Holdings

PFF has 467 holdings. The top 10 only make up about 13.5% of its AUM, making this ETF pretty well diversified.

There are many recognizable companies in the top 10 holdings, most of them being in the financial sector. This is a trend throughout the entire ETF. In fact, almost three-quarters of this ETF’s holdings are in the financial sector.

Finally, preferred stocks get credit ratings like bonds. In order to produce a yield that is competitive with that of junk bonds, PFF has to add risk by holding some non-investment grade preferred stocks.

At about 52%, PFF’s largest holding is in BBB preferred stock. The second largest holding is in BB rates preferred stock, making up about 27%. The only other really notable holding is not rated. It’s important to remember, while it’s common for assets that are very risky to be not rated, there are other reasons why some assets don’t get rated that have nothing to do with risk; for example, simply not wishing to pay the fee to the credit rating agency to rate the asset.

Why preferred stocks now

Preferred stocks are generally considered to be in between common stocks and bonds in terms of riskiness. They provide a high yield and are much more correlated with interest rates than common stock prices. As we draw nearer to a recession, I think adding PFF to your portfolio can limit equity risk and provide you with income to help stomach an equity market decline.

PFF has also shown that it is able to keep a yield roughly comparable to that of junk bonds. The chart below shows the dividend yield of PFF and SPDR Bloomberg High Yield Bond ETF (JNK).

As of right now, PFF actually has a slightly higher yield. It’s also worth noting how relatively stable PFF’s yield has been in the last decade.

We now have a better idea of what the future of interest rates will look like after Fed Chairman Powell told us that there will likely be a couple more rate hikes in 2023 and a couple of years before we should expect any rate cuts. The Fed Fund Rate is drawing near its peak, meaning that the capital depreciation that rising rates have been causing to interest rate-controlled assets is also nearing an end. With PFF, investors can be in an asset that limits equity market risk and delivers a nice dividend while they wait for rates to fall, and then profit from the capital appreciation to come when rates begin to fall.

Is the financial concentration a risk?

As mentioned before, PFF is heavily concentrated in the financial sector. After the 2023 banking crisis, many might see this as an issue. While most banks were put under pressure this past year, I think it’s important to look at why First Republic Bank and Silicon Valley Bank collapsed. First Republic Bank fell because its loan-to-deposit ratio was at 111%, while the average US bank loan-to-deposit ratio was about 64%. Silicon Valley Bank collapsed because of poor risk management and bad investments. Both of these banks were doing things that most other US banks weren’t. Now that we have passed most of the fear of a full-blown banking crisis, there is also much less risk of a widespread classic bank run. Another reason why I’m bullish on banks is that the largest banks just passed a major stress test. The stress test made by the Fed simulates a severe recession and predicts whether or not banks would survive. All major banks passed this test. I don’t think there will be any more major bank failures in the near future and I don’t think many of PFF’s holdings will have to skip dividend payments.

Credit ratings

Many of PFF’s holdings don’t have very high credit ratings. However, I think it’s important to remember that there isn’t a magical difference between BBB and BB ratings. Although BBB and investment grade and BB aren’t, BB is still just one nautch lower than BBB. There is added risk because of the BB ratings and the holdings that just aren’t rated, but this translates to higher yields. I think this risk is worth it. As I argued before, I don’t expect more bank failures and I think banks will continue to recover from the banking crisis paranoia.

Capital appreciation

With most of my income articles, I get comments saying why invest in this risky asset when it only has a slightly higher yield than short-term treasuries. As with my other recent Buy recommendations for income ETFs, the reason is that PFF has a high chance of capital appreciation when rates are cut. Short-term treasuries will experience much less capital appreciation than PFF.

Conclusion

PFF offers investors exposure to the preferred stock sector. With a 30-day SEC yield of about 6.6%, PFF provides high income and is generally less risky than common stocks. I don’t think that the high concentration of financials in this ETF is an issue. Although some of PFF’s holdings have low credit ratings, I think the risk-reward ratio is worth it. I rate PFF a Buy.