Preferred Share Funds in a Rising Rate World: Balancing Yield and Risk for Income Investors

In the current high-interest-rate environment, income-focused investors face a critical question: How to balance yield potential with risk management? Preferred share funds have emerged as a compelling alternative to traditional fixed-income assets, offering a hybrid structure that combines equity-like characteristics with bond-like income stability. However, their performance in rising rate environments-such as the aggressive hikes from 2022 to 2024-reveals both opportunities and pitfalls. This analysis evaluates the strategic value of preferred share funds, drawing on recent market trends, risk-adjusted return metrics, and portfolio management frameworks.

The Appeal of Preferred Shares: Yield, Diversification, and Hybrid Advantages

Preferred shares occupy a unique niche in the capital structure, ranking above common stock but below bonds. They offer fixed dividends, often higher than those of investment-grade bonds, and provide priority in liquidation events, as outlined in a FasterCapital overview. For example, the iShares Preferred and Income Securities ETF (PFF) currently yields 6.4%, significantly outpacing the 4.5% yield of the Bloomberg U.S. Corporate "BBB" Bond Index, according to Kiplinger. This yield advantage is particularly attractive in a high-rate environment, where traditional bonds struggle to compete with inflation-adjusted returns.

Moreover, preferred shares exhibit lower volatility than common stocks, making them a potential diversifier in equity-heavy portfolios. According to Morningstar, preferred shares have demonstrated about 94% of the volatility of stocks while generating lower returns than bonds, resulting in mixed risk-adjusted performance. However, their equity-like features-such as cumulative dividend rights and, in some cases, conversion options-offer downside protection not found in bonds, as described on Investopedia.

Performance in Rising Rate Environments: Resilience and Volatility

The 2022–2024 period provides a case study in preferred share fund dynamics. When the Federal Reserve aggressively raised rates in 2022, the ICE BofA Fixed Rate Preferred Securities Index plummeted by over 18%, a decline noted in a Global X note. This sharp decline reflected the sensitivity of preferred shares to interest rate changes, particularly for perpetual or long-maturity issues. Yet, by 2023, the index rebounded as inflation moderated and economic growth stabilized, entering what Global X describes as a "Goldilocks zone" for rates. By mid-2025, preferred securities had regained much of their lost ground, with yields near 15-year highs (5.5% yield-to-worst), according to a Schwab analysis.

This resilience underscores the importance of timing and sector diversification. Funds like the VanEck Vectors Preferred Securities ex Financials ETF (PFXF), which avoids the rate-sensitive financial sector, have mitigated volatility by focusing on utilities and industrials (see Kiplinger's coverage). Similarly, the InfraCap REIT Preferred ETF (PFFR) leverages real estate and mortgage REITs, which offer more predictable cash flows, as highlighted in a JFSP piece.

Preferred Shares vs. Bonds: Yield, Risk, and Risk-Adjusted Returns

While preferred shares offer higher yields, they come with trade-offs. Traditional bonds, particularly investment-grade corporate bonds, provide more predictable returns and seniority in the capital structure. During the 2008 financial crisis and the 2020 pandemic, preferred securities were among the hardest-hit assets, whereas bonds retained their contractual obligations, as discussed in a Schwab overview.

Risk-adjusted return metrics like the Sharpe ratio further highlight this divide. Over the past 15 years, preferred shares have underperformed bonds in terms of excess return per unit of risk, primarily due to higher credit and market volatility (see Morningstar). For instance, the yield advantage of preferreds over similarly rated bonds has narrowed to about 100 basis points in 2025, down from an average of 200 basis points historically (see Schwab). This compressed margin may not justify the added risk for conservative investors.

Strategic Allocation: Balancing Yield and Risk in 2025

In a "higher-for-longer" rate environment, strategic allocation to preferred share funds requires careful consideration of duration, sector exposure, and tax efficiency. LPL Research's Strategic and Tactical Asset Allocation Committee (STAAC) recommends reducing allocations to long-duration bonds and increasing exposure to short-term or floating-rate instruments. For preferred shares, this means favoring funds with diversified sector exposure and shorter-duration holdings to mitigate rate sensitivity.

Tax considerations also play a role. Certain preferred dividends qualify for lower tax rates, making them particularly appealing for investors in higher tax brackets (see the JFSP piece). ETFs like PFF and SPFF offer tax-advantaged structures while spreading risk across 450+ holdings (see Kiplinger). Additionally, incorporating inflation-protected assets like Treasury Inflation-Protected Securities (TIPS) and real assets (e.g., commodities, infrastructure) can further hedge against rate-driven volatility, according to Purely Investing.

Conclusion: A Strategic, Not a Substitute, Role

Preferred share funds are not a direct replacement for bonds but a complementary tool for income-focused portfolios. Their ability to deliver high yields and moderate volatility makes them suitable for investors seeking diversification in a rising rate environment. However, their sensitivity to interest rates and credit risk necessitates disciplined allocation and sector diversification. As the Federal Reserve navigates a complex macroeconomic landscape in 2025, investors should treat preferred shares as part of a broader strategy that balances yield, risk, and liquidity.