PFXF ETF Q&A: Understanding Preferred Securities

Many investors have expanded their search for income to opportunities beyond traditional debt. Preferred Securities (preferreds) have been an alternative income source of growing attention. This blog intends to answer frequently asked questions on preferreds and VanEck’s Preferred Securities ex Financials ETF (PFXF).

• Preferred Securities Background
• Preferred Securities Benefits
• Preferred Securities Ratings
• Preferreds' Impact from Interest Rate Changes
• PFXF Overview
• Exclusion of Financial Preferreds
• PFXF Dividend Payment Frequency
• PFXF's Qualification for Dividend Income
• PFXF's Distribution of Return of Capital
• PFXF’s Real Estate Exposure

What are Preferred Securities?

Preferred securities are a type of hybrid financial asset that blends the characteristics of both traditional debt and equity instruments. They represent an ownership stake in a company, but their holders do not have the same voting rights as common stockholders. Preferred stockholders are, however, typically entitled to distributions payments before any dividends can be paid to common stockholders. This "preference" in dividend distribution lends to their name.

Another unique feature of preferred shares is that preferred shareholders rank above common shareholders, but below debt holders, in the capital stack or priority of claims. Hence, if a company goes bankrupt and its assets are liquidated, preferred shareholders will receive any proceeds from the liquidation before holders of the company’s common stock.

Benefits of Preferred Securities

Preferred securities can offer several advantages for investors:

• Higher Dividend Payments: Preferred securities typically provide higher dividends than common stocks, usually paid out before dividends to common shareholders.
• Reduced Risk: Compared to common stocks, preferred securities can be less volatile. This is because preferred shareholders have a higher claim on a company's assets and earnings.
• Potential for Fixed Income: The dividends of preferred shares are often fixed, which means they can provide a steady income stream. This can be particularly beneficial to income-focused investors, such as retirees.
• Convertible Features: Some preferred securities can convert into common shares, which can provide the potential for capital appreciation if the company’s common stock price rises.

Why are Many Preferreds Not Rated?

One characteristic that many investors notice when researching the preferred securities market is that much of the universe is not rated by the major credit rating agencies like Moody’s or Standard & Poor’s. This is mainly because many preferred issuers simply chose not to pay rating agencies to rate their preferred/hybrid issues. There are a number of reasons that a company will decide not to have its preferreds rated that have nothing to do with the company's well-being, including they may already have a credit rating on much of their debt or their primary investors just don’t demand the ratings. Whatever the reason, choosing not to have a credit rating doesn’t necessarily mean the company's well-being is in jeopardy or that the preferred issue is a bad risk. However, like any debt instrument, the potential for default or delayed payment is still a risk that investors should weigh when considering an allocation to preferreds.

Are Preferreds Sensitive to Interest Rate Changes?

Preferred securities typically feature long-term maturities, typically greater than 30 years, or are even perpetual, meaning they have no maturity. For this reason, preferred securities exhibit some sensitivity to changes in interest rates. Notably, preferreds issued by financial companies tend to feature perpetual maturities more so than preferreds issued by non-financials. Excluding financial preferreds generally results in a lower portion of perpetual issues which may help lower overall maturity and reduce the impact of interest rate changes. Additionally, the portion of a preferred portfolio that is callable or convertible and the timing of the call and conversion features can impact its interest rate sensitivity.

What is PFXF?

The VanEck Preferred Securities ex Financials ETF (PFXF) offers investors differentiated exposure to the U.S.-listed preferred securities market by tracking an index that excludes securities issued by financial companies, which historically have dominated broad-based preferred indices. Excluding preferreds securities from the financial sector allows for greater sector diversification and lower concentration risk without sacrificing yield potential.

Why Exclude Financial Preferreds?

After the financial crisis of 2008, banks began issuing a significant amount of preferred stock to meet the higher capital levels required by regulators. This proliferation of preferreds issuance by financials has led to an overconcentration of the sector, which now makes up over 75% of the listed U.S. preferreds market.¹ PFXF helps limit this unnecessary sector concentration by targeting preferred securities issued by companies outside the financial sector, offering differentiated exposure, without sacrificing yield potential, compared to most broad-based preferred strategies. Beyond increased sector diversification, ex-financial preferreds also display a few other notable features, including an increased proportion of preferreds paying cumulative distributions and a lower proportion of preferreds with a call feature relative to financial preferreds.

How Often Does PFXF Pay Dividends?

The VanEck Preferred Securities ex Financials ETF (PFXF) distributes payments to its shareholders every month.

Does PFXF Pay Qualified Dividend Income?

Yes. Some preferred securities pay dividends that are treated as qualified income by the Internal Revenue Service, meaning they are taxed at the more favorable rate of long-term capital gains instead of ordinary income. Any qualified income PFXF receives from its underlying holdings will pass through to shareholders as qualified income. The portion of the fund’s dividend considered qualified income will vary as the fund’s underlying holdings change over time, but has generally ranged between approximately 15% and 25% in recent years. Please visit VanEck’s Tax Center for more information on the portion of qualified dividend income paid by PFXF.

Does PFXF Distribute Return of Capital?

Yes. Return of capital (ROC) is a payment received from an investment that is not considered taxable income, but instead reduces a shareholder's cost basis and may be recognized as a capital gain at the final sale of the investment. Real estate investment trusts (REITs) are one type of investment that typically have distributions containing a component of ROC. This is due to special tax treatments for REITs, like depreciation adjustments, that reduce taxable income without reducing the amount of cash available for distribution. Due to PFXF’s underlying exposure to REIT securities, a portion of the fund’s distribution may be considered ROC as it distributes all of its net cash received from investments (including ROC) to investors. Investors may receive a “Section 19 notice” accompanying a distribution from PFXF, which estimates the portion of PFXF’s current and fiscal year-to-date distribution comprising a return of capital. Please view PFXF’s Tax Documents and visit VanEck’s Tax Center for more information on the portion of return of capital paid by PFXF.

What type of Real Estate Exposure is in PFXF?

The real estate exposure in PFXF typically comes from REITs. This includes equity REITs which own and operate property and mortgage REITs which invest in mortgage securities and are involved in real estate financing. From a sector perspective, the REIT exposure is in PFXF tends to be well diversified across both residential and commercial real estate. In recent years, mortgage REITs providing exposure to residential and commercial real estate, as well as storage REITs provided the majority of the real estate exposure in PFXF which, in total, generally accounts for approximately 20% of the Fund’s assets.