Tag Archives: income-fund

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.

PIMCO High Income Fund: Is The Pain Over?

Summary PHK’s premium has fallen from over 50% to around 30%. That’s a big drop and well below the CEF’s 3-year average premium. So is the pain over and now the time to buy back in? The PIMCO High Income Fund (NYSE: PHK ) is a contentious closed-end fund, or CEF, that has a long history of trading at an impressive premium to its net asset value, or NAV. Right up front, I’m not a big fan of any CEF trading above its NAV, particularly at such an extreme premium. However, after such a large drop, some investors may be wondering if the hurt is over and whether now might be a good time to buy in. A little background To understand why a closed-end fund trades at a price different than its net asset value, you have to understand how CEFs differ from their mutual fund cousins. Mutual fund sponsors stand ready to buy and sell shares at the close of every trading day at NAV. Therefore, there’s a premade liquid market at NAV. Closed-end funds, meanwhile, sell a set number of shares to the public. Those shares then trade based on supply and demand on the open market. If investors like a CEF for whatever reason, they will demand a higher price to get them to sell. And if investors don’t like a CEF for some reason, they will take lower prices to get out. Thus, CEFs trade above and below their NAV. The NAV is still what the shares are worth – it is their intrinsic value, if you will. But it isn’t always what they will trade for. Using a simple example, if investors are fond of biotechnology a biotech-focused CEF might find itself trading at a 10% premium to NAV. The reason is investor sentiment; essentially investors are saying they expect good things from the CEF in the future. The important take away is that investor sentiment is the driving factor – not the actual value of the CEF’s shares. People really like PHK Closed-end funds normally trade around their NAV or at a discount. It’s unusual to see a CEF with a long history of trading well above NAV. PHK, then, is an exception to the norm. It’s long traded at a premium, and notably, at an extreme premium to its NAV. For example, its three-year average premium is nearly 50%. Its five-year average is just over 50%. People really like PHK. I’ve posited that the reason for this premium was partially because Bill Gross took over managing the fund in 2009, the year in which the premium started to widen. Since he’s no longer there, others have noted the fund’s steady distribution even through a difficult market period – notably the 2007 to 2009 recession. In the end, it’s probably a combination of the two. But whatever the reason, the CEF has a long history of trading well above its NAV. Which is why some argue that the selloff from an over 50% premium to the more recent 30% premium is a buying opportunity. This is a normal investment approach in the closed-end fund space, buying when a CEF is notably below its average premium/discount. The idea being that investor sentiment likely went too far in one direction and will eventually swing back toward the historical level. On the one hand, this makes sense for PHK. The average premium is close to 50% in recent history, so at a 30% premium, it’s fallen pretty far from the norm. In fact, this isn’t the first time there’s been such a drop. In the back half of 2012, PHK went from a roughly 75% premium down to a 25% premium before recovering to a 40% premium and eventually to the 50% and 60% levels seen earlier this year. I’d say, for aggressive investors who like to trade premiums and discounts, this is a CEF you should be looking at. Still too expensive But if you are a conservative investor, you should still avoid PHK. Why? We know with almost no doubt what PHK is worth; that’s the point of net asset value. That’s the value of PHK, no more and no less. If you buy PHK for a 30% premium, you are paying 30% more than its portfolio is worth on a per share basis. One of the reasons why playing premiums and discounts works is because you know the value of the asset you are buying – its NAV. So when a CEF is trading well below its NAV, there’s a clear catalyst for the discount to narrow. As investors realize the disconnect between price and value, they’ll correct it. PHK, however, is trading below its historical premium . Which means that anyone buying now is betting that investor sentiment will improve so that the premium gets wider. That’s akin to momentum investing in which you buy an expensive stock hoping that you can eventually sell it to someone at an even more expensive price – with little regard to its intrinsic value. There’s nothing wrong with this when it works, and it does work for some people. But it can also go horribly wrong when investors have changed their minds. Think back to the carnage in the dotcom bust, when investors realized that they didn’t like Internet companies as much as they thought they did. The companies didn’t change, investor psychology did. So, if you are a conservative investor, why bother buying something you know is overpriced? There are so many investment options in the market that taking such risks just isn’t worth it. And that’s true even taking into consideration PHK’s 15% yield. I’d rather take a yield half that and sleep well knowing that I don’t have to rely on fickle investors to buy my shares at a higher price. Or, better, yet, I’d rather buy something trading below its NAV and below its average discount, and wait for the market to realize the price disparity. With the NAV being a magnet to draw investors in to an undervalued investment opportunity. So, if you are an aggressive CEF investor looking to play discounts and premiums, PHK is definitely worth a look. Just go in knowing the game you are playing. I’d still suggest caution, but the fall from the average at PHK fits the bill for the trade. For conservative investors, don’t get sucked in by a big yield or the fall in the premium. PHK is still expensive even after its premium has fallen some 20 percentage points, and the yield just isn’t worth paying a still high 30% premium. You’ll be better off investing elsewhere. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Vanguard Wellesley Income Fund: The Reverse Of Wellington

Having written about VWELX, a reader asked my take on sister fund VWINX. The two are pretty much the reverse of each other. That, in the end, winds up being a risk issue for potential investors. A lot of investors look at bonds as a way to generate income. And that’s true. But in an asset allocation model, they are also a way to provide diversification and stability. In other words, a big part of owning bonds is safety. And that’s where a comparison of value-focused Vanguard Wellesley Income Fund (MUTF: VWINX ) and Vanguard Wellington Fund (MUTF: VWELX ) leads to some interesting findings. One down, now for number two I recently wrote an article about Vanguard Wellington . Within the comments, a reader asked if I would also take a look at sister fund Vanguard Wellesley. The comparison of the two is actually pretty interesting and highlights an important aspect of investing: risk. Wellington’s portfolio goal is to actively invest in stocks and bonds with a mix of roughly two-third stocks and one-third bonds. There’s a band around those percentages since it’s an actively managed fund, but it generally keeps pretty close to its goals. Sister fund Wellesley’s goal is the mirror image, one-third in stocks and two-thirds in bonds. And what that means for performance is very important. For example, as you might expect, Wellington outperforms bond-heavy Wellesley over the trailing one-, three-, five-, 10-, and 15-year periods through June on an annualized total return basis. That said, over the longer periods, the numbers start to get pretty close. There’s just 30 basis points or so separating the two funds over the 15-year period and around one percentage point over the trailing decade. But, the trend is intact, the fund with more stocks does, indeed, do better on an absolute basis. Interestingly, the income both funds generate is pretty close, too. Wellesley’s trailing 12-month yield is a touch under 3%. Wellington’s yield is roughly 2.5%. To be fair, a good portion of that has to do with the current low rate environment. In a different period, with higher interest rates, I would expect Wellesley’s yield advantage to be larger. But what about risk? But return and distributions aren’t the only factors to consider. Bonds are also about risk control. And on that score, these two funds have very different profiles. For example, over the trailing three years, Wellington’s standard deviation, a measure of volatility, is around 5.5. That’s a pretty low standard deviation. However, Wellesley’s number is an even lower 4. For most conservative investors, either of those two figures would be agreeable. Looking out over longer periods starts to show a bigger gap. For example, over the trailing 15-year period, Wellesley’s standard deviation is roughly 6 and Wellington’s is around 9.5. That’s a more meaningful difference. And remember that the two funds had very similar performance numbers over that span. Thus, over the trailing three years, Wellington’s Sharpe ratio of 2, a figure that measures the amount of return relative to the amount of risk taken, outdistances Wellesley’s 1.7. But over the trailing 15 years, those numbers flip, with Wellesley’s Sharpe ratio of 1 outdistancing Wellington’s 0.7 or so. Since performance over that longer term is so close, the big reason for the difference here is risk. Who’s right for what? At the end of the day, the two funds are both good options for conservative investors looking for a balanced fund. The biggest difference is really in the investor’s desire for safety. If the higher bond component in Wellesley will help you sleep better at night, then you should probably go with the more conservative of these two funds. If you don’t find solace in having more bonds in your portfolio, go with Wellington – noting that the choice is likely to lead to a slightly higher risk profile. That said, there’s a caveat. Interest rates are at historic lows. Bond prices and interest rates move in opposite directions. So when rates go down, bond prices go up. That’s been a tailwind for Wellesley for quite some time. If rates start to move higher quickly, however, that could turn into a headwind because as rates go up, bond prices go down. Wellesley’s higher debt component will mean rising rates are a bigger issue for the fund than for its sibling. However, both funds are run by the same management company and have been around a long time. They have dealt with shifting interest rates before. So this is something to keep in mind, but I wouldn’t let it deter me from purchasing either of these two well-run funds if my goal was to own them for a long time. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.