PFXF: Levered Preferred Issuers Set To Benefit From Lower Interest Rates

Summary

• VanEck Preferred Securities ex Financials ETF returns have lagged riskier common stock alternatives over the past year.
• 61.74% of ETF assets are allocated to sectors such as REITs, Utilities, and Telecoms that traditionally employ significant amounts of debt.
• The indebted preferred issuers in PFXF's portfolio will benefit from lower interest rates by the Federal Reserve.
• The monthly distribution profile boosts the Fund's appeal to income-oriented investors, and the ETF may benefit from the return of the search for yield trade.
• Exposure to long-dated preferred securities and a potential delay in Federal Reserve rate cuts are key risks for PFXF.

Introduction

The VanEck Preferred Securities ex Financials ETF (NYSEARCA:PFXF) has delivered a 6.71% return over the past year, lagging riskier alternatives such as common stocks:

Going forward, considering the ETF's sector allocation and expectations for central bank easing, I reckon PFXF is a buy for income-oriented investors with a medium risk appetite.

ETF Overview

You can access all relevant PFXF information on the VanEck website here. The ETF invests in preferred securities issued by companies operating in a variety of industries, most notably largely excluding issuers from the financial services sector. As of the end of February 2024, PFXF invested primarily in preferred stocks issued by Residential & Commercial REITs (24.80% of net assets), Electric Utilities & Independent Power Producers (20.77%), and Telecommunication Services (16.17%). The remaining industries have a combined weight of 38.26% and are listed in the breakdown below:

Curiously, the PFXF ETF has a small allocation to Banking Services (1.33% of net assets) and Investment Banking & Investment Services (0.54%) despite its overall focus on non-financial issuers.

From a geographical perspective, issuers are predominantly in the United States (90.79% of net assets), followed by Canada (3.19%), Bermuda (1.30), and the United Kingdom (0.94%). The remaining 3.77% are cash and other assets.

Large Holdings And Concentration

You can conveniently download all PFXF holdings at this link. At first glance, the circa 103 holdings make PFXF fairly diversified. However, a detailed look at the holdings list shows that PFXF holds several different securities from the same issuer, in essence reducing the ETF's diversification benefit. In the table below, I summarized the top ten holdings of PFXF by issuer, regardless of the exact type of preferred security held:

Source: Author calculations based on PFXF daily holdings, March 2024

As you can see from the table above, the top ten issuers account for a combined 49.2% of the ETF's net assets. Considering that the management fee of 0.40% accounts for the majority of the ETF's 0.41% expense ratio, you may well consider investing in some of the individual preferred stock issuers and saving on the management fee.

A Tailwind From Central Banks

Taking into account the industry and top ten issuer characteristics outlined in the previous paragraphs, we see that PFXF holdings will benefit from the expected monetary policy easing cycle by the Federal Reserve. REITs, utilities, and telecoms account for a combined 61.74% of the ETF's assets. All three industries routinely run debt-heavy capital structures. This is also evident if we look at the balance sheets of the top ten issuers, as shown in the table below:

Source: Author calculations

As you can see from the data above, PFXF's top ten issuers have significant amounts of debt in their capital structure, notwithstanding differences among individual companies. As such, PFXF issuers will benefit from lower interest rates, increasing the dividend coverage of preferred stock issues.

Risks

The high amount of debt employed by PFXF issuers adversely affects their credit metrics. As such, only 31.80% of the companies in the ETF's portfolio are rated investment grade, 34.67% are below investment grade, and 33.53% are not rated:

Considering the credit risk profile of PFXF holdings, a potential recession or a delay in Federal Reserve interest rate cuts will negatively affect the underlying profitability of PFXF issuers, potentially putting preferred distributions at risk.

PFXF's preferred securities portfolio carries a significant amount of long-term interest rate risk, with 84% of all securities perpetual or maturing in over 30 years:

However, considering that interest rates are broadly expected to decline from current levels, I see this more as a tail risk. That said, we may well see a decline in short-term rates and an increase in long-term rates, which will adversely affect PFXF's holdings.

Distributions

PFXF makes payments to ETF holders on a monthly basis for dividends and annually for capital gains. The steady income stream, most recently at around 5.74%, will grow in appeal once the Federal Reserve starts cutting interest rates this summer.

PFXF makes the ultimate maturity transformation, investing in long-duration securities and paying investors every month.

Conclusion

Considering the ETF's characteristics, I would rank PFXF as an attractive opportunity for medium-risk, income-oriented investors, with expected returns in the mid-to-high single digits going forward.

Investors in PFXF are exposed to significant duration risk stemming from the maturity profile of the underlying securities, coupled with a leveraged capital structure of the companies the ETF has allocated capital. I reckon these risks are manageable in light of the anticipated Federal Reserve rate cuts, which will benefit PFXF in two ways. Firstly, lower interest rates will improve the profitability of the indebted ETF companies, in the process boosting preferred dividend coverage. Secondly, we may see the return of the search for yield trade, where investors unable to find quality fixed-income alternatives move up the risk ladder, with preferred shares a natural first step.

Given the twin tailwinds at PFXF's back, I reckon the ETF is a buy.

Thank you for reading.