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Fund Watch

Why This REIT Is the Only Real-Estate Fund to Crack the Kiplinger ETF 20

We say goodbye to iShares U.S. Preferred Stock and hello to Schwab U.S. REIT.

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High-grade bonds should be the bedrock of your fixed-income port­folio. But tremors in bonds can rattle other parts of the market that investors view as alternative sources of income, such as preferred stocks.

See Also: Fund Fee Wars Heat Up

Preferreds fall in the “bond proxy” camp. Although preferreds trade like stocks do, with prices hovering at about $25 a share, they pay a fixed rate of interest. They also tend to yield more than comparable investment-grade bonds—a feature that should theoretically provide some protection against rising interest rates (which cause bond prices to fall). Yet exchange-traded funds that hold preferreds have suffered mightily as the broad U.S. bond market has slumped.

Between July 8 and December 31, the yield of the benchmark 10-year Treasury bond leaped from just under 1.4% to 2.4%. Over that period, iShares U.S. Preferred Stock ETF (symbol PFF, $37) lost 3.7% on a total-return basis. Meanwhile, the investment-grade segment of the U.S. bond market fell 3.1%.

The price of PFF would likely remain steady if rates stabilized at current levels, and it would appreciate if rates were to fall. But Kiplinger sees the 10-year Treasury yield hitting 3.0% by year-end, and that could lead to more pressure on the fund’s share price. Given our rate forecast, we are dropping PFF from the Kiplinger ETF 20.

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Our replacement is Schwab U.S. REIT SCHH. This ETF holds 100 real estate investment trusts—landlords that own properties such as apartment buildings, hotels, malls and offices. REITs make money primarily from rental income. They’re also cash machines for investors, partly because Uncle Sam requires them to distribute at least 90% of pretax income as dividends.

Yielding 3.6%, the Schwab ETF doesn’t pay nearly as much as funds holding preferreds. But REITs are more like dividend-growth stocks than fixed-income investments. REITs can raise rents, and they’re constantly developing and investing in new properties to boost their profits and payouts. In 2017, Bank of America Merrill Lynch expects REITs to hike distributions by an average of 4.6%.

REITs could face an uphill climb if bond yields continue to rise. Steeper long-term rates would raise financing costs for REITs, which tend to borrow heavily to buy and develop properties.

Still, even if 10-year Treasury yields hit 3% or even 4%, it’s “unlikely to be a game changer” for REITs’ growth prospects, says Merrill. Many REITs have locked in low fixed rates for debt in recent years, reducing their need to issue new bonds at higher rates, says investment firm Lazard. Rising rates usually signal that businesses are expanding, increasing demand for real estate. As long as REITs can boost profits and hike their dividends, the stocks should hold their value.

One other reason we like this fund is its rock-bottom expense ratio, the lowest of any REIT ETF: It charges just 0.07%, or 70 cents per year for every $1,000 invested.

See Also: Preferred Stocks Paying 5% or More to Income Investors