Infrastructure Capital Advisors
Income from Real Assets
Preferred stocks, often referred to as "hybrid securities," combine characteristics of both equities and fixed-income instruments. Like bonds, they provide regular income streams and hold a senior position in the capital structure relative to common equity, making them particularly appealing to income-focused investors. However, the unique complexities of preferred stocks—such as call risk, sector concentration, and sensitivity to interest rate changes—underscore the importance of active management in optimizing returns while mitigating risks. We will explore the advantages of active management in preferred stock investing, with a focus on the Virtus InfraCap U.S. Preferred Stock ETF (PFFA) as a use case.
Understanding Preferred Stocks
Preferred stocks occupy a distinct niche in corporate capital structures. They offer higher yields than common stocks and bonds, tax-advantaged dividends, and lower correlations to traditional asset classes. These features can help make them valuable tools for portfolio diversification. However, the preferred stock market presents challenges that require careful navigation:
-
Sector Concentration: The preferred stock market is heavily dominated by financial institutions such as banks and insurance companies, which account for approximately 62% of the investable universe. This concentration exposes investors to sector-specific risks (e.g., Financials performed poorly during Global Financial Crisis drawdowns).
-
Call Risk: Many preferred securities are callable at par, meaning issuers can redeem them before maturity. Investors holding callable securities trading above par face potential losses and replacement costs if these securities are redeemed.
-
Interest Rate Sensitivity: Fixed-rate preferred stocks are vulnerable to rising interest rates, which can erode their market value.
-
Credit Risk: Unlike debt instruments, issuers of preferred stocks can suspend dividend payments during periods of financial stress without triggering bankruptcy. However, according to Moody’s1, the historical default rate for preferred stocks is far lower than for high yield bonds.
Given these complexities, passive strategies that track broad indices often fall short in addressing these risks. Active management provides a more nuanced approach to navigating this intricate asset class.
Key Advantages of Active Management
Addressing Market Inefficiencies:
The potential inefficiencies in the preferred stock market allows active managers to seek opportunities while managing risks:
-
Sector Overconcentration: Passive indices allocate disproportionately to financials due to their dominance in the market. Most recently, this overexposure was evident during Q1 2023 when regional banks like First Republic Bank (FRC), Signature Bank (SBNY), and Silicon Valley Bank (SVB) failed.
-
Call Risk Oversight: Passive funds often hold callable securities with negative yield-to-call profiles, locking investors into unfavorable positions (potential losses). Active managers actively screen for such securities and can remove securities before redemptions occur.
-
Credit Quality Monitoring: Many preferred stock issues lack credit ratings from major agencies. Many passive indices include these unrated securities comprehensively, whereas active managers can conduct rigorous credit analyses to identify attractively valued but fundamentally sound securities.
We believe the dominance of passively managed ETFs—representing over 70% of assets under management (AUM) in preferred stocks—further amplifies these inefficiencies. Active managers can capitalize on this dynamic by identifying mispriced opportunities overlooked by passive strategies.
[1] 30 Year default rates from 1990 to 2019 are sourced from Moody’s Investor Services and are presented for informational purposes only.
Introducing the Virtus InfraCap U.S. Preferred Stock ETF (PFFA) - Active Management Process
Many writers and commentators are quick to compare PFFA’s strategy and investment process to other passively managed preferred funds or single stock preferred allocations, but we believe they usually miss key factors that contribute to PFFA’s success: active management, active strategies, diversification, risk management and income and total return objectives. We will briefly discuss these factors below.
Active Management
Tactical Adjustments and Allocations
-
Portfolio Tilting: Many commentators analyze PFFA’s holdings as if it was a single preferred stock or passive strategy. PFFA actively invests in a diversified basket of preferred stocks and dynamically deploys a low band of leverage (with no daily reset) to boost diversification, income and total return. For example, if the Fed pivots to increase rates, we can quickly increase exposure to floating, fixed-to-floating or other higher yielding securities, and harvest gains in less desirable securities in an effort to position PFFA for income and total return opportunities. Passively managed preferred funds track an index and rebalance infrequently (e.g., quarterly or semi-annually), thus it can take many months for these funds to rebalance and shift based on changing market environments.
-
Rebalancing Flexibility: Unlike passive funds, active managers can adjust portfolios dynamically. We can anticipate passive fund rebalances and trade accordingly to capture liquidity-driven price movements.
-
Sector Rotation: As an active manager we can quickly overweight sectors offering higher yields or better risk-adjusted returns while underweighting stressed sectors like financials during crises. It is difficult for individual investors to accomplish this with single stock preferred investments due to liquidity, instrument type and allocation sizes, and passive funds closely track various indices, which may have strict rules regarding sector investments (such as a concentration in financials or a 25% limit on real estate).
Dynamic Risk Management
-
Call Risk Management: We monitor call dates daily to minimize exposure to callable securities trading above par. By doing so, we can preserve capital and capture profits before redemptions occur. We monitor parity preferreds and are able to arbitrage price differences that may arise. By harvesting income and price differences, the fund can capture accrued income, reduce interest expense by paying down borrowing, reduce exposure to preferred stock position, and facilitate new investment opportunities. Individual investors likely do not have metrics, trading capacity, borrowing capacity, or the ability to generate new investment ideas in a timely manner to accomplish this strategy on their own. Passively managed funds track an index that may not consider call risk in the index rules and are unable to trade daily to accomplish this strategy.
-
Interest Rate Sensitivity: Fixed-rate preferreds are particularly vulnerable during periods of rising interest rates. As a manager, we can mitigate this risk by diversifying between fixed-rate and fixed-to-floating-rate securities. Fixed-to-floating-rate preferreds convert to floating rates after a specified period, offering protection against rising rates. We can also seek total return and high current income by arbitraging gaps that emerge when: (1) floating preferreds trade in-line with their fixed rate preferred parity issues, (2) fixed-to-floating preferreds are converting in the near future at higher coupon rates, and (3) management is encouraged to call these floating preferreds at par value when interest rates are high.
-
Credit and Default Risk Mitigation: Continuous assessment of issuers' financial health helps us avoid defaults or dividend suspensions. This vigilance helps to obtain income and total return objectives. We monitor portfolio concentrations daily and can limit exposure to preferred stocks or sell preferreds of companies that are not well positioned. We can be in contact with company management in the event there is a corporate action that may impact the preferred stock and actively manage credit situations that passive funds or individual investors are unable to do (such as negotiating with a company or seeking to enforce securities rights with a company). Many commentators do not consider the benefits that active strategies can provide to the fund and consider its portfolio holdings as permanent positions, whereas we are consistently turning over the portfolio to harvest gains, reduce concentrations and seek new income and total return opportunities.
Seizing Market Opportunities
-
New Issues Participation: We can invest in newly issued preferred securities before they are included in indices. Unlike passive funds and individual investors, we also have substantial capacity to participate in new opportunities as we deploy leverage for these purposes. We may temporarily increase portfolio leverage and simultaneously harvest gains in securities that are fully valued or are no longer providing diversification or other portfolio benefits. These newly issued securities often appreciate in value due to technical factors when passive funds subsequently add them.
-
M&A Activity: During mergers or acquisitions, we can identify opportunities where credit profiles improve or premiums are offered for redemption.
-
Market Dislocations: We can quickly use leverage and deploy capital during periods of market stress when prices are undervalued. This strategy benefit is generally missed by commentators as passive funds and individual investors may not have capacity or the ability to purchase preferreds when they are trading at discounts.
Potential Performance Benefits of Active Management
The Virtus InfraCap U.S. Preferred Stock ETF (PFFA) has demonstrated how active management can deliver stronger outcomes:
-
Higher Yields: PFFA seeks to consistently offer higher distribution yields than its passively-managed counterparts by optimizing yield-to-call metrics and employing modest leverage. Commentators review semi-annual financial statements and draw incorrect conclusions. Semi-annual financial statements are a snapshot prepared at point in time on a fiscal year basis, not on a calendar year basis. Commentators have incorrectly made assumptions that the dividend is not covered or that the we need to use capital gains to cover the dividends. These commentators lack an understanding of the fund, specifically that the fund uses leverage and that the interest and expense associated with the use of leverage reduces net investment income, which can actually create tax deferrals for investors. As income accrues and we harvest gains, the character of the distribution paid to investors may change, and there are tax revisions and adjustments as well. We seek to effectively harvest income when we believe doing so is advantageous. This process facilitates the active strategies and objectives, income and total return. Investors should review portfolio holdings, their prices, and investment yields to obtain a yield for the portfolio. The 30-day SEC yield should also be reviewed as it is a standardized measure of the interest and dividend income an ETF or mutual fund earns over a 30-day period, annualized and expressed as a percentage of the fund's net asset value (NAV) per share. It is designed to provide investors with a consistent way to compare the income-generating potential of different funds.
-
Improved Diversification: By reducing concentration in financials and increasing exposure to sectors like real estate and utilities, PFFA aims to enhance portfolio diversification while maintaining attractive income generation. We believe this is a prime component of success if deployed strategically by active managers. Unlike individual investors, an In-Kind ETF can utilize creation/redemption mechanisms to facilitate portfolio construction, which can also have various tax benefits. In addition, passive funds may have less basket flexibility than actively managed funds, which can actively construct their basket and portfolio without having to closely track an index. We believe fund diversification can facilitate income and total return.
-
Risk Controls: PFFA uses rigorous risk controls through credit quality screens and sector-based allocations driven by relative value rather than market capitalization or rating agency assigned credit ratings. We believe our active approach to security selection and risk management helps the fund successfully achieve its strategies. For example we believe PFFA’s active approach allowed it to navigate the regional banking crisis in Q1 2023 more effectively than many passive funds that were overexposed to failing institutions.
Preferred stocks can offer advantages for income-focused investors, but require careful navigation due to their inherent complexities. Commentators are quick to draw conclusions without due consideration for the active strategies deployed and active investment process. Passive strategies often fail to address key risks such as sector concentration, call risk, interest rate sensitivity, and credit quality issues and individual investors may have difficulty replicating the active process of an In-Kind ETF with leverage and diversification. In contrast, we seek to provide a disciplined approach that maximizes returns while mitigating risks.
By deploying strategic security selection, dynamic risk management, and tactical adjustments, we aim to deliver higher yields, better diversification, and enhanced total returns compared to passive strategies. The Virtus InfraCap U.S. Preferred Stock ETF (PFFA) has over $1B in AUM and we believe demonstrates how active management, active leverage, and active strategies can be used to pursue long-term success in the preferred stock market.
For financial professionals and investors seeking income with reduced volatility for their clients’ portfolios, we believe actively managed preferred stock funds represent a compelling solution. In an increasingly complex investment landscape, we believe PFFA can be a vital tool for navigating the intricacies of this hybrid asset class effectively.
About Us
Infrastructure Capital Advisors, LLC (ICA) is an SEC-registered investment advisor that manages exchange traded funds (ETFs) and a series of private funds. The firm was formed in 2012 and is based in New York City. ICA seeks current income opportunities as a primary objective in most, but not all, of ICA's investing activities. Please read the prospectus carefully before investing. For more information about the Funds, Fund strategies or InfraCap, please reach out to Craig Starr at 212-763-8336 (Craig.Starr@icmllc.com).
Please consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. The prospectus contains this and other information about the Fund. Contact us at 1-888-383-0553 or visit www.virtus.com for a copy of the Fund's prospectus. Read the prospectus carefully before you invest or send money.
DISCLOSURE:
The information presented represents our subjective belief and should not be construed as investment advice. The information and opinions provided should not be taken as specific advice on the merits of any investment decision. Investors should make their own decisions regarding any investments mentioned, and their prospects based on such investors’ own review of publicly available information and should not rely on the information contained herein. Infrastructure Capital Advisors, LLC (“ICA”) nor any of its affiliates accepts any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of the information contained herein. This bio includes information based on data and sources from ICA and third-party sources. We believe that the data is reliable. We have not sought, nor have we received, permission from any third party to include their information in this article. Many of the statements in this article reflect our subjective belief. The comparative illustration provided is for information use only and should not be used for the basis of making an investment decision. All data and sector information are obtained from Bloomberg. Financial Professional Use only. Not for public distribution. Past performance and sector data is not indicative of future results. The links to the fund fact sheets will provide standardized performance and risk disclosures. *Morningstar ratings are based on risk-adjusted returns. Strong ratings are not indicative of positive fund performance. Morningstar Rating: Five star ranking awards for three year performance was prepared by Morningstar, an independent third party. As of 04/30/2025, PFFA was rated 3 stars out of 68 funds, 5 stars out of 56 funds and has no rating out of 38 funds within the US Fund Preferred Stock category for the 3-, 5- and 10 year periods, respectively.
Exchange-Traded Funds (ETF): The value of an ETF may be more volatile than the underlying portfolio of securities it is designed to track. The costs to the portfolio of owning shares of an ETF may exceed the cost of investing directly in the underlying securities. Preferred Stocks: Preferred stocks may decline in price, fail to pay dividends, or be illiquid. Leverage: When the Fund leverages its portfolio, the Fund may be less liquid and/or may liquidate positions at an unfavorable time, and the value of the Fund’s shares will be more volatile and sensitive to market movements. Non-Diversified: The portfolio is not diversified and may be more susceptible to factors negatively impacting its holdings to the extent the portfolio invests more of its assets in the securities of fewer issuers than would a diversified portfolio. Market Price/NAV: At the time of purchase and/or sale, an investor’s shares may have a market price that is above or below the fund’s NAV, which may increase the investor’s risk of loss. Market Volatility: The value of the securities in the portfolio may go up or down in response to the prospects of individual companies and/or general economic conditions. Local, regional, or global events such as war or military conflict, terrorism, pandemic, or recession could impact the portfolio, including hampering the ability of the portfolio’s manager(s) to invest its assets as intended. Prospectus: For additional information on risks, please see the fund’s prospectus. PFFA, PFFR, and AMZA are distributed by VP Distributors, LLC, member FINRA and subsidiary of Virtus Investment Partners, Inc.
