PowerShares, the exchange-traded fund unit of Invesco and the fourth-largest sponsor of ETFs in the US, launched the PowerShares Variable Rate Preferred Portfolio ETF (VRP) on May 1. The fund is US’s first variable rate preferred stock ETF product.
Preferred stocks have been the toast of institutional investors due to their potential for price appreciation and impressive dividend yields. Yet the slow and inevitable rise in yields has exposed these securities’ key investment risk: like other fixed income securities that pay a preset coupon over long horizons, they can slide in value and offset income gains they produce.
A study by Merrill Lynch showed in the eight months, since Ben Bernanke announced the end of Federal Reserve stimulus, traditional preferred stocks shed 10 percent of their value. To counter this problem, a fairly new type of preferred stocks was introduced by corporations, known as variable rate preferreds or VRPs. The same study showed VRPs lost 5 percent, or half the rate of traditional preferreds, in the final eight months of 2013. You should note that most of the returns from fixed-income securities usually come from the coupons.
VRPs started to catch the fancy of investors just 18 to 24 months ago and are more geared towards institutional investors, meaning few retail investors can access them. The new PowerShares ETF bridges this gap and helps retail investors access this new asset class.
Variable-rate preferred securities are typically issued at rates lower than similar credit quality preferred stocks since the issuer bears most of the credit risk. Accordingly, VRP securities are priced more like short maturity instruments and generally display less price volatility than fixed-rate preferred securities. Due to this better risk-reward profile, variable-rate preferreds fare better than traditional preferreds, which behave more like long-duration bonds.
The new fund should prove attractive to income investors in a rising interest rate environment because most preferred stocks are either perpetual or sport long maturities. Technically, VRPs are like fixed/float securities because they pay a fixed coupon for the first five-ten years after which they become callable. The coupon thereafter typically varies at a rate of three-month LIBOR plus a spread that generally floats between 300 and 750 basis points if the issuer doesn’t exercise the call option.
VRP tracks the Wells Fargo Hybrid and Preferred Securities Floating and Variable Rate Index, and the fund will generally invest at least 90 percent of total assets in preferred securities that comprise the index.The average yield-to-maturity of the index is 4.4 percent, which is well below the six percent yields offered by traditional preferreds. That’s the trade-off for low volatility and small interest-rate risk. Still, VRPs offer more attractive yields than short- or long-term government bonds.
The fund has an expense ratio of 0.5 percent.
Disclosure: No holdings