PFFA: Good Preferred Shares ETF, Not A Good Time To Buy (Rating Downgrade)

mikkelwilliam I last covered the Virtus InfraCap U.S. Preferred Stock ETF (NYSEARCA:PFFA) in late 2023. In that article, I argued that PFFA’s strong dividend yield and stabilizing economic conditions made the fund a buy. PFFA has returned 9.0% since, outperforming most bonds and bond sub-asset classes, with positive capital gains and dividend growth. Since that article, the fund’s dividend yield has dropped from 9.7% to 9.3%, with credit spreads tightening across the board. Although prospective returns and income remain high, spreads are simply not all that attractive, and the fund could see significant losses if credit spreads normalize or economic conditions worsen. As such, I would not be investing in the fund at the present time. PFFA – Basics Investment Manager: Virtus Expense Ratio: 2.52% Dividend Yield: 9.26% Leverage Ratio: 20.30% Total Returns 5Y CAGR: 5.62% PFFA – Overview and Analysis Portfolio and Holdings PFFA is an actively-managed, leveraged ETF focusing on U.S. preferred shares. These securities have characteristics of both equities and bonds but, in practice, behave like non-investment grade bonds or loans. PFFA is somewhat diversified, with investments in almost 200 securities, and exposure to several sectors. Concentration is somewhat above-average, with the fund’s top ten holdings accounting for almost 30% of its portfolio. PFFA PFFA is less diversified than average though, with the largest bond ETFs investing in several bond sub-asset classes with more balanced sector weights. These include the Vanguard Total Bond Market Index Fund ETF Shares (BND) and the iShares Core U.S. Aggregate Bond ETF (AGG). The largest preferred shares ETF in the market, the iShares Preferred and Income Securities ETF (PFF), invests in more than 400 securities too, more than twice those of PFFA too. PFFA is a leveraged ETF, with leverage ratios in the 20% – 30% range. Tightening credit spreads have caused leverage ratios to hover around 20% right now, in the lower end of the range. Leverage boosts income, returns, risk, volatility, and losses during downturns. PFFA’s leverage is of a reasonable magnitude, and not excessive. With the above in mind, let’s have a look at the fund’s positives and negatives, starting with the positives. Positives and Benefits PFFA’s key positive is its strong 9.3% dividend yield. It is an incredibly strong yield on an absolute basis, and quite a bit higher than that of most bonds and bond sub-asset classes. Data by YCharts It is also higher than most other preferred shares ETFs in the market, including the benchmark iShares Preferred and Income Securities ETF: Data by YCharts As per CEFConnect, the average preferred shares CEF sports an 8.0% distribution rate, quite a bit lower than PFFA. So, PFFA’s 9.3% distribution rate is quite high, and higher than that of most of its peers, be those ETFs, CEFs, or funds focusing on other types of bonds and fixed-income securities. It is a strong yield across the board. It is also mostly covered, although exact figures vary. The fund sports an SEC yield, which measures a fund’s underlying generation of income, of 9.7%, more than enough to cover its distributions. PFFA Looking at its latest net investment income, the fund sports a distribution coverage ratio of 82%, significantly worse. Latest figures are for late 2023 though, and conditions could have improved these past few months. Rates have risen too, after all. PFFA’s distribution growth track-record seems somewhere between adequate and poor. Distributions were cut by over 30% in early 2020, almost certainly due to the pandemic and attendant rate cuts. Distributions have seen steady, single-digit annual growth since, but remain over 10% lower than pre-pandemic. PFFA’s strong 9.3% distribution yield is the fund’s most important benefit and positive. It’s strong recent returns and momentum are something of a positive too, with the fund seeing incredibly strong returns since interest rates started to stabilize in early 2023. Data by YCharts Risks and Negatives PFFA suffers from several important risks and negatives. These include the fund’s use of leverage, which boosts overall portfolio risk, volatility, and drawdowns. Leverage could prove particularly ruinous during severe downturns. PFFA suffered a drawdown of over 50% during the pandemic and was down by over 28% by the middle of the year. Losses were significantly greater than average. Data by YCharts PFFA’s losses were partly due to its leverage, but only partly: the fund is simply not leveraged enough to suffer 3x – 5x losses as its benchmark. Losses were almost certainly boosted by weak credit quality. As per the fund’s latest annual report, most of its investments are not rated, and these tend to be of below-average quality. PFFA’s weak credit quality is another significant risk and negative for the fund, and almost certainly responsible for most of the losses above. Current economic conditions seem broadly, if weakly, negative for the fund as well. Credit spreads have tightened as default rates rise, so risks are higher while yields are (comparatively) lower. Risk-adjusted yields and expected returns are much weaker as a result. Data as per JPMorgan, take special note of the recent movements in the bottom right. JPMorgan Guide to the Markets PFFA’s combination of leverage, weak credit quality, and unfavorable economic conditions, make it a risky investment with somewhat weak risk-adjusted yields or returns. Overall, I find the fund too risky for a buy rating, at least right now. PFFA – Looking Back I have written about PFFA a few times in the past. I’ve been bullish since late 2022, due to the fund’s strong yield. I turned neutral in this article due to the aforementioned deterioration in economic conditions, especially their impact on spreads. PFFA’s spread relative to benchmark treasury ETFs have declined by around 1.5% – 3.0% since late 2022, depending on the specific time period in question (lots of rate volatility at the time). Data by YCharts Such a massive decrease in spreads reduces the comparative strength of the fund, sufficiently so for me to turn neutral. I’m actually much more bullish on high-yield bonds and similar securities than average, as although credit spreads are tight, yields themselves remain high, and higher than their historical averages. This was a close call for me, but the leverage really makes a lot of difference here, especially considering the fund’s prior 2020 returns. Conclusion PFFA offers investors a high 9.3% distribution yield with strong momentum behind its back. Risks and tight spreads make the fund a hold for me.

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