Advent Claymore Convertible Securities & Income Fund: Risk and Reward

Preferred shares are a special class of investments that have a higher claim to a company's assets than common stock but do not have the voting rights that common stock holders have. They also tend to pay a higher dividend than common stock and companies would normally cut or eliminate common stock dividends before they consider cutting preferred share dividends. Some preferred shares are convertible into common stocks. You can learn more about preferred shares here.

In light of the strong rally we have experienced over the last few weeks in the broad stock market and the financial sector in specific, which is up nearly 90% off its March 9 lows, I recently sold my preferred share ETF, iShares S&P U.S. Preferred Stock Index (PFF). While I am attracted to the 11% yield of the preferred shares ETF, over 80% of PFF's portfolio consists of financial stocks. In the uncertain investing environment we live in, preferred share funds have seen highly volatile swings, losing nearly half their value in a matter of weeks and rebounding just as quickly.

Even before I sold my position in PFF, I started looking for alternative preferred shares funds that had less exposure to the financial sector and an attractive yield. The kicker would be to find such a fund that was actually selling at a discount to the value of the assets it held.

The Advent Claymore Convertible Securities & Income Fund (AVK) is a closed-end fund that has only 20% exposure to the financial sector, sports a distribution rate of 9.29% and is currently selling at a nearly 10% discount to Net Asset Value or NAV. If you are interested in learning more about closed-end funds, you can check out the February 2007 investment newsletter where I discussed a long/short strategy as applied to closed-end funds in great detail.

There are no free lunches in investing and if you are wondering where the catch lies with AVK, the key risk to keep in mind is that AVK is a leveraged fund with about 48.24% leverage. Leverage appears to have come down over the last few weeks and the 1940 Act Asset Coverage Ratio has increased to 223%.

According to the Investment Company Act of 1940, if the coverage ratio for preferred shares falls below 200%, the fund must suspend dividend payments. You can read the specifics of the 1940 Act regarding coverage ratios here. The 1.22% expense ratio of AVK is certainly much higher than the 0.48% charged by PFF but the portfolio holdings in AVK are diversified across sectors and include stocks like Mylan (MYL), Teva Pharmaceuticals (TEVA), Transocean (RIG), Amgen (AMGN) and Intel (INTC). As some of you will realize, these are companies that have been discussed either in the newsletters or the SINLetter blog and are more transparent than financial stocks.

I am going to add AVK to my personal portfolio but will not be adding it to the SINLetter model portfolio as I do not expect capital appreciation from this fund and the model portfolio does not take dividends into account.

Comments

[G-Man:]

Frankly, I would not have sold the PFF. If the current yield is 11%, and you sold at a profit, your effective yield was higher than 11%, which is more than the average annual return of the SPX since inception (including dividends - it is 10.1%).

The financials are getting a free ride to make money from the Fed, making non-payment of the preferred dividend highly unlikely. I feel the current yield overestimates the risk associated with the holdings.

Also, you can buy cheap puts on the XLF and insure your entire PFF position if you want, so why sell?

May 29 10:36 AM

[remicksmind:]

Where can I find a periodic listing of convertibles showing the
yield, conversion parity, premium price due to increased stock price into which the security is convertible and basic value yield due to a low price for the stock into which the security is convertible?

Sep 15 05:50 PM