Tuesday, May 09, 2006

A preferred stock ETF, Why Not?

Since the 2003 Tax act which lowered the tax rate of dividends, more investors have been seeking equity income. There are now eight dividend focused ETFs with almost $7 billion in assets. But there is hollow spot, because there are no ETFs devoted to preferred stock, which is the logical investment for fixed dividend income.

Preferred stock is senior equity. In exchange for a limited claim on the company’s assets and future growth; preferred shares are entitled to a dividend preference and fixed rate of dividends. Before any dividends can be paid on the common shares, all dividends owed to the preferred stock classes must be satisfied.

Unlike common stock which typically yields 1.7% (S&P 500 average), preferred shares tend to pay between 5% and 9%. Dividends on traditional preferred stock are "qualified dividends", which means you only pay 15% tax on them. A second ETF that would be useful, would be a hybrid preferred ETF that invested in preferred shares that did not pay qualified dividends. There is a huge market for these types of shares which are issued by REITs and capital funding trusts. This ETF would have a somewhat higher yield than one that restricted itself to traditional preferreds only.

A preferred stock ETF that tracked traditional preferred shares rated BB+ and better, would yield at least twice as much as high yield dividend ETFs like (PEY) or (FDL) currently yield (~3%). At the same time, preferred shares are less affected by the gyrations of the stock market. They are mostly sensitive to interest rates and credit quality. This makes them an excellent source of diversification.

Investment advisor Flaherty & Crumrine specializes in preferred stock. They run several closed end funds that invest in preferred stock, as well as sponsoring http://www.preferredstockguide.com/ which has a searchable database and educational materials.

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