A soon-to-launch exchange-traded fund is offering a potential solution to the conundrum of the need for income when interest rates are rising: exposure to variable-rate preferred stocks.
The Invesco PowerShares Variable Rate Preferred Portfolio (VRP), which is scheduled to be listed on May 1, tracks a Wells Fargo index of variable-rate preferred stocks as well as other hybrid securities that are “functionally similar,” according to the fund's filing with the Securities and Exchange Commission. This type of stock offers a stream of dividend income that varies with interest rates, providing protection against unexpected rate hikes.
“This product could appeal to investors seeking income in a rising rate environment,” said Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ.
The average dividend yield to maturity on the stocks in the index is 4.4% as of March 31, substantially more income than could be generated from variable-rate bonds, according to Lorraine Wang, head of global ETF products and research at Invesco PowerShares Capital Management. For example, floating-rate corporate notes typically yield between 0.5% and 1%, she said.
The greater potential yield is partly because preferred stocks are more risky, Mr. Rosenbluth said. In the case of default, preferred stockholders are second in line to bondholders for payments.
Variable-rate preferred stocks are slightly less lucrative than their fixed-rate equivalents, Ms. Wang added. Fixed-rate preferred stocks tend to yield about 1.5% more, mainly as compensation for higher interest rate risk.
The index that the fund tracks, called the Wells Fargo Hybrid and Preferred Securities Floating and Variable Rate Index, mainly offers exposure to the financial sector, which issues the majority of these products, Ms. Wang said. Financials constitute about 90% of the index, with energy coming in second at 5%.
The main risk associated with variable-rate investments is that interest rates may not rise as much as expected, Mr. Rosenbluth said. This would leave investors saddled with a product that underperforms its fixed-rate equivalent.
Another important feature of variable-rate preferred stocks is limited upside, he said. Where common stocks tend to climb when a company's prospects improve, preferred stocks' response tends to be much more modest. This is because the stocks tend to remunerate investors with a fixed payout scheme — such as dividends that vary with interest rates — limiting the benefit to shareholders of improved company earnings.
“These investments are a happy medium between stocks and bonds,” Mr. Rosenbluth said. “They have some benefits of both, but not the full benefits of either.”