Ming Lo Investing

ETF Watch: PFF, PGF, BAC Preferred Stock – More Like a Bond or a Stock?

Posted by admin on August 11, 2010  |  1 Comment

Preferred stock is a hybrid beast.  It has both debt and equity characteristics.  Anyone can tell you that.  What’s harder is whether they can tell you when it’s more like a stock, or when its more like a bond.  In the current environment, preferreds are more like a bond.

So first a bit of background.  Here’s the characteristics of preferred stock:

• senior to common stock, but junior to debt in the financial structure
• offers dividends that must be paid before dividends on common is paid
• dividends often not guaranteed (call “non-cumulative”), unlike bonds where they are usually guaranteed.  preferred dividends are sometimes guaranteed and paid another time if not payable in the current period (known as “cumulative preferred”), but non-cumulative is more common
• sometimes convertible into common stock
• callable at the option of the corporation, meaning that the company can decided to buy you out at a pre-determined price
• non-voting

So that’s the textbook definition.  In practice, investors are interested in preferreds usually because they have a higher yield, and they’re looking for income.  Let’s take a look at them in the real world, and especially the current environment.  Below, you will see charts of the PFF (preferred stock ETF), the PGF (the financial preferred stock ETF) and BAC-D, the Bank of America Preferred.  You’ll notice a few things:

First, notice that the PFF and the PGF charts look almost identical, and that the BAC-D is very similar, but more extreme.  So we know that they all trade similarly.

Second, compare each chart to the S&P, which is marked as the light blue line on each chart.  You’ll notice that the preferreds all trade very roughly in line with the S&P, with the exception of two periods that we will discuss for the moment. So generally, the preferreds can be expected to trade in line with the S&P.  This makes sense, because they are like a stock.  But there are exceptions.

Third, let’s take a look at the first exception, the period from mid-March to late-April.  You’ll see that on each chart, the preferred stock started falling in mid-March while the S&P was rising.  This actually makes sense if you think about it.  At this time, markets were very bullish and were on a run.  So money came out of the fixed income instruments (like preferreds) and into the market, where the return was expected to be higher.  Conclusion #1: preferreds diverge from the market in bullish markets as investors sell preferreds in favor of higher returns in straight equities.

Fourth, the second exception to the idea that preferreds trade roughly in like with the market.  On each chart, let’s look at the period between May to present day, August.  In the May-June period, you’ll see that the preferred was roughly in line with market, but it was actually more stable – preferreds didn’t dip as much as the market, when the market did dip.  This also makes sense because the bond-like features of the preferred (the dividends) make it an instruments that investors will hold on to when equities are weak.  Now look at the July-August period.  You’ll notice that the preferreds far outperform the market.  In fact, they’ve taken off as the market went sideways and faltered.  During this time, investors fled into bonds, and bond yields have been falling steadily.  Here’s a chart of the 10-Year Treasury Yield Index.  It mirrors Treasury yields, or interest rates.  When the yield falls, Treasury prices are rising.  As you can see, yields have been falling off a cliff as investors, fearful of a worsening economy, have run into Treasuries.  As they buy Treasuries, the price of Treasuries rises and yields fall.

Therefore, conclusion #2: in very bearish markets, preferreds are more like a bond, because of the yield offered. Investors, seeking safety, buy preferreds and bid up their price.

Preferreds are a great investment in times of distress.  But they warrant some caution, because preferreds will lag when the market reverses.

I am long PGF and BAC for myself and/or for clients.

ETF Watch: PGF

Posted by admin on January 13, 2010  |  No Comments

I inherited a portfolio that contained the PGF.  At first blush, the PGF looks great: it has a 9% yield. Pundits like Cramer love it.But let’s get serious and do some homework.

The ETF. So if you look up the PGF (http://www.invescopowershares.com/products/overview.aspx?ticker=PGF), it’s the PowerShares Financial Preferred Portfolio. It’s a fund based on Wachovia’s Hybrid & Preferred Securities Financial Index (WHPS Financial Index). You can’t invest in an index, so the PGF seeks to track the WHPS Index. The fund will invest at least 90% of its total assets in securities that are in the base index.

Fund Holdings. So the first obvious question is, what’s in this thing? When you go to the product homepage (above), there’s a little link that says “Fund Holdings”. That takes you to this page: http://www.invescopowershares.com/products/holdings.aspx?ticker=PGF. You’ll see that as of 1/12/2010, there were 39 holdings and the top holdings were Bank of America, Barclays, ING, Wells Fargo and JP Morgan Chase preferreds. Looking over the list, there’s a few banks whose financial condition I’m not familiar with, such as AEGON, ING and REPSOL; and many banks that I’m comfortable with, such as BAC, Barclays, Wells Fargo, JP morgan, HSBC, Credit Suisse, Goldman Sachs, Santander and Prudential. There’s a couple holdings whose stock I wouldn’t buy – Royal Bank of Scotland and National Bank of Greece.

Overall, I’m fine with the holdings because I believe that the worst of the financial crisis is over. There could still be problems this year, particularly this summer. But in the long-term, we’re on an uptrend in financials. While I wouldn’t buy Royal Bank of Scotland and National Bank of Greece, I don’t think they’re going under.

Fund Yield, Price and Expenses. Other key facts include a 30-day yield of 7.59% and a 12-month yield of 8.39%. It trades at $17.12 and has an expense ratio of 0.68%, a bit high but much lower than a mutual fund.

Risks. So let’s look at the risks and downsides. First, let’s start with the equity risk. The PGF is comprised of financials (as the name implies). Critics say that you would be getting a 8-9% yield but would be risking a 100% loss. Still, as mentioned, I believe the worst of the financial crisis is over. We may still have a dip in the medium-term, but in the longer-term, we’re on an uptrend as the recovery continues. In my opinion, the biggest risk is a dip in the medium-term as latent financial problems (e.g., foreclosures) surface

Later, banks could also take a hit when the yield curve flattens. Longer-term rates will rise. Because banks borrow short and lend long, this will, at first, help banks. But eventually the Fed will raise short-term rates, causing the yield curve to flatten. This will lead to lower margins for banks. This is something to watch out for, particularly toward the end of the year

Second, let’s look at the preferred security itself. Preferred stock has a fixed dividend, and that makes it vulnerable to interest rates. So when interest rates rise, new securities are a better investment because they offer a higher rate of return than existing preferred. This would imply that the price of the preferred stock would fall. On the other hand, banks perform better with a steeper yield curve, and that could increase the value of the preferreds. So the impact on the PGF itself is unclear. More than likely, the PGF will have to sell off declining securities and reinvest in newer securities, leading to some losses in the fund. Truth be told, all this is theoretical at this point. We will have to see what happens when rates rise, be vigilant and be prepared to exit if the value drops significantly.

Eventually, the yield on preferred stock will drop. An 8.5% to 9.0% yield is a reflection of our times, when financial stocks are worth less than they are in “normal” times with normalized earnings. Another factor to watch out for in the longer term.

Other Considerations. So here are some other pluses and minuses of preferred stocks:

- Preferred shares are higher in the capital structure than common stock

- Dividends must be paid to preferred stock owners before being paid to common stock holders

- Dividends are fixed

- Preferred stock holders have no voting rights

- Because preferred shares have debt characteristics (fixed dividend, like a bond), they also have less potential for share price appreciation

- Many preferred shares dividends are qualified dividends taxed at 15%, unlike bond income, which is taxed at regular rates. The tax treatment of dividends may change the coming years.

Managing the Investment. Tom Lydon, an ETF guru and author of the ETF trend Playbook, has three rules for managing ETF investments:

- maintain an 8% stop loss on ETFs

- if the ETF falls below the 50-day moving average, that’s a red flag. If it falls below the 200-day moving average, then sell

- don’t chase markets that are too hot, such as in 2000.

He also says that you should only invest in ETFs trading above their 200-day moving averages. If you look at a chart of the S&P since 1994, it was best to stay out of the market when the S&P traded below it’s 200-day moving average.

Here’s an example of applying one of his guidelines. If you buy an ETF trading 15% above its 200-day moving average, then you should have an 8% stop loss.

Interestingly enough, these guidelines could apply to more than just ETFs. Not a bad set of guidelines to work with.

Other ETFs. So the PGF isn’t the only preferred game in town. There’s the iShares S&P U.S. Preferred Stock Index (PFF), created in March 2007. As the name implies, this tracks the S&P U.S. Preferred Stock Index. It invests at least 90% of assets in securities that comprise the index, which includes stocks listed on the NYSE, AMEX or NASDAQ. Companies have a market cap of at least $100 million and the fund is non-diversified. The PFF’s expense ratio is 0.48%, a low turnover of 12% and the yield is about 8.58%. Currently, it trades at $37.63.

There’s also the PowerShares Preferred (PGX), which seeks to track the Merrill Lynch Fixed Rate Preferred Securities Index, established in January 2008. At least 80% of total assets are invested in the Merrill Lynch Preferred Index. The expense ratio is 0.5%, it has a high turnover of 52% and its current yield is 8.09%. As of today, it trades at $13.68.

Conclusion. Generally, I like the preferred stock ETFs at this point in time. There’s some risk that prices may fall after this point, but eventually, in the longer-term, prices should rise as we get closer to normalized earnings. At that point, yields will fall, so it will have to be re-evaluated as an investment. In the meantime, I will be holding on to the PGF in the portfolio I’m managing. And of course, watching out for the risks outlined above.

ETF Watch: Why You Should Avoid the USO Right Now

Posted by admin on April 7, 2009  |  No Comments

Tuesday, April 7, 2009 – 6:35 PM PST. Some time ago, a friend of mine was buying the USO as a way of playing oil. Turns out, the USO didn’t quite track the price of oil. She asked me about it, but at the time, I didn’t know why. Now I do.

So let’s start with the facts. West Texas Intermediate (WTI) Crude was $46.34 per barrel on 1/2/09. Yesterday, on 4/6/09, WTI was $51.05. That’s a 10.2% gain. In contrast, the USO has fallen from $35.63 on 1/2/09 to $30.23 yesteraday. Year-to-date, that’s a 15.2% loss.

Why does this happen? That’s because the USO doesn’t actually trade crude oil, it trades crude oil futures. That’s a whole different story. You might think that the USO takes your money, buys a barrel of oil, and then sells it later. Fact is, the USO trades futures, which are actually a derivative. It’s like trading options, rather than the underlying stock. Like options, those futures expire. Because of that, the USO is constantly buying new futures contracts. If you think that costs more money, the answer is yes, it does.

In periods when the price of oil is expected to rise (called “contango”), longer term futures cost more the farther away they are in time. For example, today, the May ’09 contract costs $48.18; the June ’09 contract costs $51.08, and the July contract costs $53.57. The USO has to keep rolling forward its position in order to stay invested, but as you can, it becomes increasingly expensive to do so.

It makes sense then, that the USO should do well when the price of oil is expected to decline, a situation referred to as “backwardation”. In this case, the price of futures contracts decline with time. So as the USO rolls its position forward, new contracts became cheaper, resulting in greater gains.

So for as long as we have contango, the USO can be expected to under perform relative to the price of crude. This applies to other similar ETFs. Before investing, you should read the ETF’s prospectus carefully.