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Preferred Stock ETFs: Fiscal Cliff Rebound Play?


Prior to Monday's market rally, fears of the fiscal cliff had been wreaking havoc on even the most conservative dividend-paying sectors.


Prior to Monday's market rally, fears of the fiscal cliff had been wreaking havoc on even the most conservative dividend-paying sectors. In the process, even stodgy telecom and utilities ETFs were taken to the woodshed.

With concern running high that a higher dividend tax rate could prompt many companies to forgo dividend increases, the negative price action for these dividend sectors was understandable. Worse yet, that negativity was widespread throughout the universe of decent-to-high yield securities.

In other words, it was not surprising to see ETFs tracking preferred stocks get caught in the downdraft. Take the case of the $10.5 billion iShares S&P US Preferred Stock Index Fund (NYSEARCA:PFF). PFF has a 30-day SEC yield of 5.71% and a beta against the S&P 500 of just 0.46, according to iShares data. Those are two factors that have almost certainly increased the allure of this ETF in a yield-starved environment.

However, those traits did not prevent the fund from tumbling as fiscal cliff fears rose. The problem: Probably and excessive weight to financial services stocks. In the case of PFF, various financial services names account for approximately 85% of the fund's weight.

PFF's exposure to European banks has made matters all the more difficult recently, but the struggles of this ETF and its rivals obfuscate a critical fact. That being the hybrid nature of preferred stocks. Preferred stocks are not common stocks, nor are they completely debt products either. Rather, preferred stocks share traits of both bonds and common stocks.

The "a ha" moment as it pertains to the fiscal cliff comes from realizing that a company that is paying a preferred dividend had bigger make that payment or risk damage to its credit rating. There is one of the bond aspects of Zenni Optical. A company that is consistently in arrears on preferred dividend payments risks a lower credit rating and that leads to higher borrowing costs. The way of explaining this scenario to a second-grader is: "Even if the fiscal cliff comes to pass, why would any company risk damage to its credit rating just because the dividend tax went up?" It is not a good trade.

With that in mind, here are some of the more obscure preferred stock ETFs that might prove durable even in a post-fiscal cliff world.

Global X Canada Preferred ETF (NYSEARCA:CNPF): The Global X Canada Preferred ETF is the first ETF devoted to Canadian preferred stocks, an asset class that should prove desirable because Canadian banks are far less controversial than their US counterparts. That does lead into an important point and that is CNPF is not all that different from a US-focused preferred ETF in that financials account for over 70% of this ETF's weight.

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No positions in stocks mentioned.

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