PFF Preferred Stock ETF: 60% Bank Exposure with Call Provisions Capping Upside

An analysis of the iShares Preferred and Income Securities ETF (PFF) reveals that between 60% and 70% of its $14 billion portfolio consists of preferred stocks issued by U.S. banks and insurers. Most of these securities feature call provisions, a structural characteristic that may limit potential returns for investors.

Call Provisions: A Double-Edged Sword

A call provision gives the issuer (bank or insurer) the right to repurchase the preferred stock at a set price after a certain date. In a rising interest rate environment, the fund performs well, as preferreds remain outstanding and pay attractive dividends. The problem arises when interest rates begin to fall.

How Call Provisions Affect Returns

When interest rates decline, it becomes economical for banks to call their preferreds and reissue them at a lower coupon. This means PFF investors may see their holdings called away, forcing them to reinvest at lower yields. Thus, the seemingly attractive distribution yield (around 6.5%) may not be sustainable, and investors could miss out on the capital appreciation that typically occurs when rates fall.

What This Means for Investors

While PFF offers a relatively high distribution yield, investors should be aware of the embedded call risk. In a falling rate environment, fund holders may not benefit from price appreciation as expected and could face reinvestment at lower yields. Investors are advised to review portfolio holdings and understand the call terms of each issue before making an investment decision.