A Preferred Stock ETF With A Secret Strategy
Most of the time, preferred stock shares are pretty boring. However, the rapid increase in interest rates has turned a subset of the preferred universe into potentially outstanding investment opportunities.
You could dig out the right preferred stocks yourself or invest in an ETF that does precisely that.
Let me show you how to do both for some above-average income…
Preferred shares get their name because they have preference over common shares for dividend payments. I tell my subscribers that the preferred dividends are guaranteed, as long as the company is paying common stock dividends.
Preferred stocks pay dividends based on a par value and a coupon rate. Most preferreds have a par of $25.00. If a preferred has, for example, a coupon rate of 6%, the preferred will pay $1.50 per year, divided into four quarterly dividends.
After issue, preferred shares trade on the stock exchanges and can be priced above or below the par value. A preferred trading below par will have a current yield higher than the coupon rate. For example, the Rithm Capital Corp 7.5% Preferred A (RITM.PA) shares trade for $22.50, giving a current yield of 8.3%.
Preferred shares are callable by the issuer. They become callable at a set date. The RITM.PA preferred shares were issued in June 2019. They become callable on August 15, 2024. Whether or not an issuer calls in a preferred is at that issuer’s discretion. It is common for preferred shares to continue trading for years after the initial call date.
A subset of preferred shares switch from a fixed coupon rate to a variable rate when they become callable. The rapid increase in interest rates over the last year and a half turned fixed-to-variable preferred stocks into a very interesting investment opportunity.
As noted above, RITM.PA becomes callable in August next year. At that time, if the shares are not called in, the coupon rate switches to SOFR plus 5.802%. (SOFR, the Secured Overnight Financing Rate recently replaced LIBOR). SOFR currently is 5.3%. If RITM.PA became callable today, the rate paid would jump to 11.102%, calculated on the $25.00 par value.
When a fixed-to-variable preferred stock becomes callable, the issuer can either call in the shares at par or start to pay the variable dividend rate. At the current SOFR rate, the dividends for this type of preferred share will skyrocket. At the same time, many preferred shares in this group trade for less than par. These factors provide the investment opportunity.
If you buy RITM.PA now, you will earn 8.3% over the next year. If the shares get called in next August, you will receive $2.50, or an 11% gain on your purchase. If Rithm Capital lets the shares go variable, you will earn a double-digit coupon rate based on the current SOFR, and the RITM.PA share price would be a 12.3% yield on the current ($22.50) share price.
The challenge to this strategy would be to go through the 500 different preferred stocks to find the ones that go fixed-to-variable soon and are trading at a discount to par. Fortunately, there is an easier way to benefit from this investment opportunity. The Virtus InfraCap U.S. Preferred Stock ETF (PFFA) is an actively managed preferred stock ETF. The PFFA managers are very aware of the fixed-to-variable opportunity and actively invest in preferred stocks that offer the investment potential outlined above. PFFA pays stable monthly dividends and currently yields 10%.
This post originally appeared at Investors Alley.
Category: Dividend Yield
