The Preferred Way To Play

By Aaron Levitt | September 25, 2009 AAA

There are certainly risks involved with investing in the financial sector of the market. While bank stocks have been on a tear lately, as represented by the Financial Select Sector SPDR's (NYSE: XLF) recent rise from its $5 low to its current $15 price, there are still some concerns in the segment. Nationalization fears have eased, but commercial real estate loan and credit card defaults are still in many analysts' minds. Add this to the decreased or non-existent dividend yields the group once possessed and the appeal of finance stocks diminishes. However, there is a way to play finance stocks with less risk and more distribution yield.

IN PICTURES:
Digging Out Of Debt In 8 Steps


The Preferred Method
As a security that blends both debt and stock-like attributes, preferred stock is a great choice in the current uncertain environment for investing in finance stocks. The nature of these shares includes priority over common stockholders on earnings and assets in the event of liquidation and bankruptcy, second to bond holders. In addition, preferred shares have a fixed dividend, paid before common stockholders.

Cons for the share structure include the lack of voting rights and capped upside in the way of callability. The market for preferred shares is increasing in strength. Last year, dumping by hedge funds and other institutions brought yields on these shares to the 20 to 30% range.

However, the share class as a whole has returned to normal with yields averaging in the 8 to 10% range as investors have become more optimistic on the world economy. (For an overview on preferred shares, check out A Primer On Preferred Stocks.)

For retail investors it can be costly and difficult to purchase individual preferred shares. Many preferreds trade just a few thousand shares a day and can be research intensive as some financial institutions have several share classes each with their own dividend payment structures. Exchange traded funds offer individual retail investors the opportunity to allocate a portion of their portfolios towards preferreds.

The Big Three ETFs
All three of the major exchange traded funds in the sector are well off their respected 52-week lows, but still offer dividend yields in the 8% range and future price appreciation if the global economy begins to grow. With nearly $2.7 billion in assets, the iShares S&P U.S. Preferred Stock Index (NYSE: PFF) is the behemoth in the sector. The fund spreads its bets among a collection of 96 different preferred stocks with an 80% weighting towards financial stocks. The fund currently yields 8.50%.

From INVESCO's (NYSE: IVZ) successful PowerShares line of ETFs comes two preferred based funds, PowerShares Financial Preferred (AMEX: PGF) and the PowerShares Preferred Portfolio (AMEX: PGX). The PGX is more of general preferred fund similar to the iShares ETF. It spices its 86% weighting towards financial stocks with holdings in Xcel Energy's (NYSE: XEL) and Comcast's (Nasdaq: CMCSA) preferred issues as well as others. For its diversity, the PowerShares Preferred offers a slightly lower yield of 8.14% versus the PGF's yield of 8.9%.

The Bottom Line
While the economy seems to be improving, there are several big risks still ahead for the financial sector. In order to invest in the market segment, preferred shares make a compelling case. The relative safety of the share type and income opportunities available via investment in preferreds make it an ideal way for investors to get their feet wet in the banking sector. Exchange traded funds make it easy to add the security type to their portfolios.

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