Investors in search of solid income from their portfolios often select preferred stocks rather than Treasury securities or ETFs based on Treasury bonds. One reason behind this decision is that preferred stocks generally pay dividends of approximately 6% per year. As of April 20, 2016, the 10-year Treasury yield was up to 1.85% after opening the session at 1.78%.

Preferred shares combine the features of stocks and bonds. An important advantage of owning preferred shares rather than bonds is that preferred shares' dividends are taxed as long-term capital gains, rather than income. The interest paid on Treasuries and corporate bonds is taxed as ordinary income. However, investors must be mindful of the IRS rules on qualified dividends, because not all dividends are taxed at the lower rate.

General Risks

A key risk of preferred stocks is that they are sensitive to interest rates, as is the case with bonds. Because preferred stocks usually pay dividends at a fixed rate in the 6% range, the share price falls as prevailing interest rates increase. As Treasury bond yields approach a preferred stock’s dividend rate, demand for the stock declines, sending its price lower. The safe haven provided by Treasuries becomes a disincentive for assuming the risks of stock ownership.

Preferred stocks also present credit risks and industry sector risks. Additionally, lower credit ratings signal increased risk of a company’s insolvency. Industry sectors have their own particular risks, as demonstrated by the hardships endured by the oil industry during 2015 and 2016.

Another risk shared by most preferred stocks and bonds is call risk, since most preferred shares allow the issuing company to redeem the shares on demand, before the actual redemption date for the shares. This usually happens when interest rates fall. The issuing company may then redeem those shares for a price specified in the prospectus.

Particular Risks

Preferred stocks are rated by the same credit agencies that rate bonds. The top three rating agencies are Moody’s, Standard & Poor’s and Fitch Ratings. While preferred stocks can earn a rating of investment grade, many have ratings below BBB and are considered speculative or junk. Some preferred stock ETFs limit their holdings to investment-grade stocks, while others include a significant allocation of speculative stocks. The cautious investor must become familiar with the particular investment strategy and portfolio holdings of the ETF.

iShares U.S. Preferred Stock ETF

The iShares U.S. Preferred Stock ETF (NYSEARCA: PFF) is the largest preferred stock ETF with total assets exceeding $14.89 billion, as of April 20, 2016. Its average daily trading volume exceeds 600,000 shares. PFF has a trailing 12-month dividend yield of 5.79%. This ETF tracks the performance of the S&P U.S. Preferred Stock Index. It has an expense ratio of 0.47%.

The ETF's 289 portfolio holdings are heavily skewed toward the financial sector, with banking sector securities comprising 42.33% of its weight, as of April 19, 2016. As of the same time, diversified financial securities and the insurance sector accounted for 17.83 and 8.99% of the portfolio weight, respectively. These weightings indicate a total financial sector allocation of 69.15%. As of March 31, 2016, 83.6% of the fund's underlying index weight was allocated to financial sector securities. This lack of diversification could alienate a significant number of risk-averse investors beyond those who fear another financial crisis.

First Trust Preferred Securities and Income ETF

Of the nine major preferred stock ETFs, the First Trust Preferred Securities and Income ETF (NYSEARCA: FPE) was the fourth largest, with 158 holdings and total net assets of over $787 million, as of April 20, 2016. The fund has a trailing 12-month dividend yield of 5.97%. This is an actively managed ETF, and it has an expense ratio of 0.85%. Its average daily trading volume is approximately 274,000 shares.

As of March 31, 2016, only 19.42% of FPE's assets were of investment grade (BBB or higher). Speculative-grade investments, with ratings from BBB- through B-, accounted for 49.05% of the fund’s holdings. Around 18.78% of its holdings were unrated. Risk-averse investors might also be concerned about this fund’s lack of diversification, as it has a heavy allocation toward the financial sector.

As of April 19, 2016, the banking sector accounted for 38.92% of the fund's portfolio weight, followed by insurance securities at 18.31% and capital markets at 11.62%. With an additional 5.67% of the fund’s assets invested in consumer finance sector securities, as well as 5.06% in the consumer financial services sector, this ETF had 79.61% of its total assets allocated toward the financial sector.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.