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.