Tag Archives: closed-end-funds

Preferred Shares With International Exposure And 9% Yield

Summary Preferred shares as an investment category is dominated by US securities. Two funds offer opportunities to diversify the preferred shares allocation in an income portfolio. These funds are discussed here. With this article, I conclude my look at preferred-shares closed-end funds. In the first ( Where Are the Best Opportunities in Preferred Shares? ), I presented the data on 16 funds in the category. I followed up with a closer look at my choices among the purely domestic fund ( These Top Choices for Preferred Shares Will Bring Nearly 9% Yields to Your Income Portfolio ). Here, I conclude with the two international funds in the category. The Funds Flaherty & Crumrine Dynamic Preferred & Income Fund Inc (NYSE: DFP ) First Trust Intermediate Duration Preferred & Income Fund (NYSE: FPF ) Both funds score high enough on my initial screen to make it to the overall short list. DFP stood out on the basis of its recent returns (especially on NAV) and FPF scored high for its high distribution (top of the category for market distribution, and second on NAV) and its high level (third in category) of undistributed net investment income backing up the distribution yields. I put off examining them in detail because I wanted to focus on the domestic funds, all of which had an extended historical record. DFP and FPF are more recent funds; both, coincidentally, have the same inception date of May 24, 2013. Discount/Premium Discounts are identical (-7.95%) for each, which is about mid-range for the category. And for both, the discounts have been shrinking. DFP’s Z-scores are positive for 3 and 6 months. For 3 months it’s 1.03. For FPF, Z-scores are positive for 3, 6, and 12 months; for 3 months it’s 1.1. Both funds showed a similar pattern in the evolution of their discounts. Both held a premium valuation at inception and soon thereafter, then, as is typical of closed-end funds, the premiums fell to discounts as the fund began trading. This can be seen in these charts (from cefconnect ) of their full premium/discount histories. First DFP (click to enlarge) and FPF. (click to enlarge) FPF falls below the category trend line on the Discount vs. NAV Distribution chart (see previous articles for this chart). DFP is above it. As I’ve noted, this relationship favors funds that fall below the trend line. Distributions FPF’s yield on price is a category-leading 9.01%, from a 8.29% NAV distribution yield. DFP’s distributions are mid-category, both on price (8.59%) and NAV (7.91%). DFP has negative UNII (undistributed net investment income) at -2.5% of its distribution, which value places it ahead of only two other funds, neither of which made the cut for the short list. FPF is positive with excess UNII at 5.28% of its distribution, which is third for the metric in the category Two funds examined previously, JPC and HPI , lead. FPF has paid out special distributions in each of its two years of activity; it would appear shareholders can expect another for 2015. When the special distribution is included in yield calculations, FPF’s yield for the past twelve months is 9.8%. Preferred shares dividends may be qualified for the 15% tax rate for most investors. For the 2014 tax year, FPF reported 56.53% of its income from qualified dividends, and DFP reported 70.20%. This is similar to the pattern we saw previously in the domestic funds where the Flaherty & Crumrine funds had the highest levels of qualified dividends. Portfolios These two are the only funds in the category that have holdings extending beyond US borders. All of the others are 100% invested in US companies. For DFP, the non-US segment of the portfolio is 21.3%; for FPF it is more than twice that, 48.7%. FPF also has a more diverse group of countries represented as we see in the tables below: (click to enlarge) Both funds are leveraged, as are all the funds in this category. DFP has 33.6% leverage, which is the category median, and FPF has 30.99% ranking seventh or one off the median. DFP’s portfolio is 97.8% invested in preferred shares. FPF’s objective strategy statement ( here ) states that it “will invest at least 80% of its Managed Assets in a portfolio of preferred and other income-producing securities.” The fund is listed as having 29.8% of its portfolio in preferreds and 67.3% is in a category described as “investment funds.” From the most recent holdings statement, I take that larger category to be fixed-rate capital preferred securities, hybrid securities that combine the features of both corporate bonds and preferred stock. These are typically issued by utility companies and financial institutions and accrue certain tax benefits to the issuing institution. According to Fidelity, these typically provide higher yields and typically are senior to preferred or common stock. Morningstar lists a weighted average credit score of BBB- for DFP. No average is calculated for FPF, but the fund’s most recent report ( here ) shows a distribution centered on BBB-. FPF’s credit quality distribution is shown below: (click to enlarge) Both funds’ portfolios are heavily concentrated in the financial sector. This is how FPF reports the industry distribution for its holdings: (click to enlarge) And this is how DFP’s holdings break down on a sector level: Summary These funds offer international diversification to the preferred shares investor. FPF, with its greater exposure to non-US holdings and a wider range of countries in its portfolio, does this more effectively. The primary reason to venture into these funds, in my view, is for international exposure and FPF does that more effectively than DFP. So, the edge here goes to FPF. Both have a reasonable discount, but those discounts are well above (i.e., less negative, therefore less discounted) recent mean values. Neither has an edge on this metric. DPF offers a high yield, but it comes with the downside of negative UNII. FPF’s yield is higher and one might reasonably expect a year-end special distribution from the fund as well. FPF has a stronger recent total return record (11.5% for one year, second to the John Hancock funds ( HPF , HPI and HPS discussed earlier). A clear win for FPF here. I’m not sure that I’d consider either fund a timely buy right now, but between the two, the clear choice would have to be FPF for its stronger yield, favorable UNII, and its more diverse portfolio.

Is It Time To Buy Convertible Bond CEFs?

Summary Convertible bond CEFs have been hit hard lately, resulting in historically large discounts. Convertible bond CEFs offer enticing income while you wait for the sector to recover. My pick is NCZ, which is currently selling at a large discount and provides a distribution of 12%. In February of this year, I wrote an article advising investors to beware of convertible bond closed end funds (CEFs). At that time, I cautioned that premiums could disappear. As it turned out, my fears was well founded. In July of this year, the premiums morphed into large discounts. After the selloff, I now believe some of these CEFs are selling at bargain levels. Part of my reasoning is based on the currently large negative Z-scores associated with these CEFs. Z-score is a metric popularized by Morningstar and is a measures how far a discount (or premium) is from the mean discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A negative Z-score indicates that the current discount is larger than the average discount over the past year. A Z-score more negative than minus 2 is relatively rare, occurring less than 2.25% of the time. A good source for reviewing Z-scores is the CEFAnalyzer website. Most of the convertible CEFs currently have Z-scores more negative than minus 2. Before jumping into analysis of the risk versus rewards of convertible CEFs, I will recap some of the characteristics of this asset class. A “convertible security” is an investment that can be converted into a company’s common stocks. A company will typically issue a convertible security to lower the cost of raising money. For example, many investors are willing to accept a lower payout because of the conversion feature. The conversion formula is fixed and specifies the conditions that will allow the holder to convert into common stock. Therefore the performance of a convertible is heavily influenced by the price action of the underlying stock. As the stock prices approaches or exceeds the “conversion price” the convertible tends to act more like an equity. If the stock price is far below the conversion price, the convertible acts more like a bond or preferred share. Convertible bond CEFs usually contain a mixture of convertible securities and high yield bonds. The attraction of convertible CEFs is that they offer upside potential with some protection on the downside. Granted that with a portfolio of high yield bonds and convertibles the downside protection is limited. However, over the long run, the fund manager seeks to obtain the “sweet spot” between fixed income and equity that will enable him to outperform his peers. The funds that were analyzed in my previous article are summarized below. AGIC Convertible and Income (NYSE: NCV ). Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 14%. It was not until the second half of 2015 that the fund began selling at a discount. The five year average has been a premium of 7.5% and the 1 year average was still a premium of 5.7%. The fund is now selling at a discount of over 10% and has a Z-score of negative 2.55. The portfolio consists of a combination of convertible bonds (58%) and high yield bonds (41%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution is 12.5%, funded by income with no return of capital (NYSE: ROC ). AGIC Convertible and Income II (NYSE: NCZ ). This is a sister fund to NCV and over the past 5 years, the prices of these two funds have been 90% correlated. So if you invest in one of these funds, you gain virtually no diversification from investing in the other. Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 17%. It was not until the second half of 2015 that the fund began selling at a discount. The five year average has been a premium of 10.4% and the 1 year average was a premium of 9.4%. The fund currently sells for a discount 9.4% and has a Z-score of negative 2.4. The portfolio consists of a combination of convertible bonds (57%) and high yield bonds (42%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution is 12.4%, funded by income with no ROC. Calamos Convertible and High Yield (NASDAQ: CHY ). Over the past 5 years this CEF has sold for a both a discount and a premium. The premium was as high as 5% in early 2015 but by late 2015 the fund sold at a discount. The 5 year average discount has been 2.9% but over the past year, the fund averaged a slight premium of 0.3%. The current discount is 8.6%. The portfolio consists of a combination of convertible bonds (55%) and high yield bonds (40%). Less than 15% of the holdings are investment grade. The fund utilizes 29% leverage and has an expense ratio of 1.5%. The distribution is 10.6%, funded by income with only a small amount of ROC. The UNII is negative and quite large when compared with the distribution, which may be a concern for maintaining future distributions. Calamos Convertible Opportunities and Income (NASDAQ: CHI ). Over the past 5 years this CEF has sold for a both a discount and a premium, alternating frequently between discount and premium. The premium was as high as 4% in 2011 but by late 2015 the fund sold at a large discount approaching 14%. The 5 year average discount has been less than 1% and over the past year, the fund’s average a discount has been 1.8%. The fund is currently selling at an 11% discount and has a Z-score of negative 2.05. The portfolio consists of a combination of convertible bonds (56%) and high yield bonds (39%). Less than 15% of the holdings are investment grade. The fund utilizes 28% leverage and has an expense ratio of 1.5%. The distribution is 10.9%, funded by income with only a very small amount of ROC. The UNII is negative and quite large when compared with the distribution, which is red flag for future distributions. This is a sister fund to CHY but over the past 5 years these two funds have only been 80% correlated so you receive a small amount diversification if you own both of these CEFs. Advent Claymore Convertible and Income (NYSE: AVK ). Over the past 5 years, this CEF has always sold at a discount. The five year average has been a discount over 8% and the 1 year average is an even higher discount of 10.5%. The current discount is a large 16.8%, which translates into a Z-score negative 2.78. The portfolio consists of a combination of convertible bonds (64%) and high yield bonds (31%). About 10% of the holdings are investment grade. The fund utilizes 37% leverage and has an expense ratio of 2%. The distribution is 8.1%, funded by income with a substantial (40%) ROC component. UNII is negative and large compared with the distribution. Advent Claymore Convertible Securities and Income (NYSE: AGC ). Over the past 5 years, this CEF has usually sold at a discount. The only premium was for a short time in 2010 and was less than a 5% premium. The five year average has been a discount of 8.7% and the 1 year average is an even higher discount of 13.8%. The current discount is over 17%, which translates into a Z-score of negative 1.95. The portfolio consists of a combination of convertible bonds (63%) and high yield bonds (28%). The portfolio also has a small (5%) equity component. About 10% of the holdings are investment grade. The fund utilizes 40% leverage and has an expense ratio of 3.1%. The distribution is 10.1%, funded by income with a substantial (70%) ROC component. UNII is negative and large compared with the distribution. Even though AGC is in the same family as AVK, the prices of these CEFs have been less than 60% correlated over the past 5 years. As a reference, I compared the performance of the convertible CEFs to the following exchange traded fund (ETF). SPDR Barclays Convertible Securities (NYSEARCA: CWB ) . This is the largest and most liquid convertible bond ETF. The fund was launched in 2009 and holds about 100 convertible bonds. ETFs are constructed so that they typically sell very near NAV, so there is no discount or premium. ETF has an expense ratio of 0.4% and yielded 4.5% over the past year. To assess the performance of the selected CEFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds over the past 5 years (from August, 2010 to August, 2015). The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 1. Note that the rate of return is based on price, not Net Asset Value (NAV). (click to enlarge) Figure 1: Reward versus risk over past 5 years The figure indicates that there has been a wide range of returns and volatilities associated with convertibles CEFs. For example, NCV had a high return but also a high volatility. Was the return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each fund. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I also plotted a red line that represents the Sharpe Ratio of NCV. If an asset is above the line, it has a higher Sharpe Ratio than NCV, which means it has a higher risk-adjusted return. Conversely, if an asset is below the line, the reward-to-risk is worse than NCV. Some interesting observations are apparent from the plot. With the exception of AGC, the convertible CEFs had a respectable return over the past 5 years even though they recently sold off. Since CWB did not sell at a premium or a discount, it is not surprising that it had the best risk-adjusted performance over the period of the analysis. Looking at only CEFs, CHY, CHI, and NCV had nearly the same risk-adjusted performance. NCZ was close behind. AGC was the worst performer and only barely stayed in positive territory. The volatility of convertible CEFs ranged from about 15% to 17% (this is similar to the volatility of the S&P 500 over the same period) The 5 year look-back data shows how these funds have performed in the past. However, the real question is how they will perform in the future when the bull market in convertibles returns. Of course, no one knows, but we can obtain some insight by looking at the most recent bull market period from June, 2012 to September, 2014. Figure 2 plots the risk versus reward for the funds over this bull market time frame. As expected, all the funds did well. The performance of the CEFs were tightly bunched but NCZ was the clear leader among the CEFs. Somewhat surprisingly, CWB still turned in the best risk-adjusted performance. However, NCZ had the best return on an absolute basis. (click to enlarge) Figure 2 Risk versus reward over a convertible bull market Bottom Line Convertible bond CEFs have taken it on the chin lately and the discounts have widened to historic proportions. Is it time to buy these CEFs? To my mind, the answer is yes, especially NCZ. NCZ is currently selling at a discount, which is rare. If the discount reverts back to the mean, you will receive a capital gain along with collecting 12% in distributions. Not a bad combination! Of course, the discount could widen and it may time a long time for this CEF to recover, but I am willing to wait. CHY has had exceptional performance in the past and is also selling at steep discounts. This would be another alternative but I am a little worried about the large UNII and ROC. If you are risk adverse, you may want to consider CWB. There is no doubt this is the best in terms of risk-adjusted performance. However, you will not receive any “reversion to the mean” benefits. I normally choose asset with the best risk-adjusted returns but in this case, I am willing to take a slight gamble and go with NCZ. This is a special situation where I think I can capitalize on the selloff in CEFs and hope for that the large discount associated with this CEF will revert back to the mean.

Where Are The Best Opportunities In Preferred Shares?

Preferred shares belong in every income portfolio. My preference is to use closed-end funds for a preferred shares allocation. In this article I survey all closed-end funds that cover this category with emphasis on identifying leading candidates. Every income portfolio needs an allocation to preferred shares. It will come as no surprise to regular readers when I say I prefer to get mine from CEFs (closed-end funds). It’s my view that there are two areas where CEFs excel relative to competing instruments. One is in the tax-free, municipal bond category and the other is preferred shares. In this article I look at the range of offerings in preferred shares CEFs. There are 16 preferred shares funds listed on cefconnect . Funds Market Cap ($M) Cohen & Steers Ltd Duration Preferred & Income Fund, Inc. (NYSE: LDP ) $663.35 Cohen & Steers Select Preferred & Income Fund, Inc. (NYSE: PSF ) $280.60 Flaherty & Crumrine Dynamic Preferred & Income Fund Inc (NYSE: DFP ) $428.16 Flaherty & Crumrine Preferred Securities Income Fund Inc (NYSE: FFC ) $806.35 Flaherty & Crumrine Total Return Fund Inc (NYSE: FLC ) $185.10 Flaherty & Crumrine Preferred Income Fund Inc (NYSE: PFD ) $139.80 Flaherty & Crumrine Preferred Income Opportunity Fund Inc (NYSE: PFO ) $127.24 First Trust Intermediate Duration Preferred & Income Fund (NYSE: FPF ) $1,315.02 John Hancock Preferred Income Fund Ii (NYSE: HPF ) $405.14 John Hancock Preferred Income Fund (NYSE: HPI ) $502.51 John Hancock Preferred Income Fund Iii (NYSE: HPS ) $529.13 John Hancock Premium Dividend Fund (NYSE: PDT ) $630.31 Nuveen Quality Preferred Income Fund 3 (NYSE: JHP ) $195.68 Nuveen Preferred Income Opportunities Fund (NYSE: JPC ) $878.56 Nuveen Quality Preferred Income Fund 2 (NYSE: JPS ) $1,089.51 Nuveen Quality Preferred Income Fund (NYSE: JTP ) $525.58 CEFs offer powerful advantages in the preferred shares space. First there is leverage. Ok, I know I just wrote an article questioning the value of leverage ( Is Leverage Really an Advantage in Equity Closed End-Funds? ) but the key word in that title is “equity.” Of course preferred shares do fall under the rubric of equity investments, but in my mind they skirt the line between fixed-income and equity, pushing more toward the fixed-income side. So, here I do consider leverage an advantage. And in any case, there is no choice; all 16 preferred shares CEFs are leveraged within a fairly tight range. Effective leverage varies from 28.65% to 33.92%. The median is 33.59%, so the distribution is clearly top heavy as this distribution chart shows. A second advantage is skilled management. This comes at a cost; these funds average 1.7% fees, about a quarter of which is interest cost for leverage. In this category, as in many of the fixed-income categories, managers have tools available that most individuals do not. Leverage is one of them. Another is the ability to use hedging strategies in response to significant increases in long-term interest rates. And a third is access to credit information along with the quantitative tools to use that information to an investor’s best advantage. And a final factor is the opportunity to purchase CEFs at a discount, something not generally possible in other investment vehicles. Every one of these 16 CEFs is priced at a discount. These advantages combine to generate income appreciably greater than a comparable portfolio of preferred shares an individual can assemble, or that one obtains from ETFs. To support that generalization, I preset these data comparing the median CEF to iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) and Preferred Portfolio ( PGX ), the two largest ETFs in the category. Fund Yield PFF 6.13% PGX 6.01% CEF minimum 7.69% CEF median 8.64% CEF maximum 9.01% The median yielding CEF is outpacing PFF by 41% and PGX by 44%. The difference cannot be accounted for by the 33% leverage alone. Management priorities, driven by investor priorities, are a part of the mix; this may show up in CEFs having higher levels of credit risk, for example, as management caters a fund to appeal to investors willing to accept that risk for the higher yields it can bring. Another important factor is premium/discount status. Large premiums and discounts are part of the nature of CEFs, but not a factor in ETFs or open-end mutual funds. The importance of discount shows up in enhanced yields. The median fund’s yield on NAV is 7.82%, well below the median yield at market seen in the table (8.64%). It is the median discount of -9.03% that gets the additional 82 basis point of yield into the investor’s pocket. Of course, the median yielding and the median discounted fund are not necessarily the same fund, I’m just making a point here and using median values to illustrate it. One can readily do the math for individual funds. So what are the yields of our 16 preferred shares CEFs? Here we have yield at market, and yield on NAV. How do funds find their market price levels relative to their NAVs? Obviously there are multiple complex factors, but among the most important is the tendency for the market to drive yields to an equilibrium level via discounts or premiums. This can be seen graphically in the next chart where discount is plotted against distribution on NAV. This trend is seen in every category of CEFs I’ve looked at. There are exceptions, of course, but in general lower NAV yields produce deeper discounts. FFC with the highest NAV yield is the least discounted fund. In fact, discount territory is a relatively unaccustomed place for FFC to find itself in. When I last wrote about preferreds a year ago ( This Fund May Be Your Best Call for Preferred Shares ), I opined that FFC at a discount was a smart buy. That discount was nearly the same as today’s. I continue to feel that way and certainly consider it attractive at its present level. If we accept the tendency to move toward NAV Distribution/Discount equilibrium, the best values should be found among the funds below the trend line. Eliot Mintz had discussed this in relation to tax-free muni-bond CEFs ( Municpal Bond Closed End Funds – How to Find the Best Values ). By this criterion, FPF, JPC, the John Hancock Funds (HPS, HPI and HPF) and PSF merit a close look. A second aspect of CEFs that has a tendency to revert to mean values is Premium/Discount status. This tendency is well documented in the academic research on the subject and can provide a source of alpha. This is measured by Z-Scores. More negative Z-Scores indicates current prices are more discounted than the mean premium/discount. Sometimes one can find buying opportunities among funds that have deeply negative Z-scores. They are also useful in providing an overall picture of trends in a category over time. Here’s how the 16 funds fare for this metric. PDT and PSF are much more discounted today than their 3-, 6- or 12-month means by large margins. FPF, which looked interesting from the Distribution/Discount analysis, has been reducing its discount steadily and now stands about one standard deviation form its three-month mean. The John Hancock funds (HPF, HPI, HPS) show appealing Z-Scores indicating again that they could merit our attention. This report is intended as a broad survey of the preferred shares CEF category. I will be following up with a closer look at the funds that look most attractive in the next installment. We’ll look at management strategies, portfolio quality, sustainability of distributions and other factors that go into choosing a fund. Among my “best bets” that I’ll be covering are FFC, which I consider the best of the field but possibly not a buy at this time; FPF; and the John Hancock funds. Meanwhile I and other readers would certainly appreciate hearing from readers regarding their opinions on the subject of preferred shares funds.