With the market for income-oriented investments as volatile as it has been lately, it's worth looking around at alternative income producing investments that might be attractive going forward. One area of the markets investors should consider is closed-end funds, or CEFs. These funds trade just like stocks so they are easy to buy and sell, and they have the advantage that the book value of their underlying holdings is recorded daily in the form of the CEF's Net Asset Value (NAV).
The goal of investors in this space should be to buy high-yielding CEFs that invest in stocks or bonds within the investors risk tolerance and which also trade at or below net asset value. By finding CEFs that trade below NAV, it's like the investor is getting a discount on the current market prices of the stocks or bonds that fund holds. Finally, if possible, investors should try and find funds that pay dividends out of income rather than a return of capital (though many funds use small returns of capital to even out dividends on a monthly basis, which is not generally a problem).
Given these restrictions, there are a couple of closed-end funds that stand out right now as being particularly attractive, but one of the best also happens to have large investments in floating rate notes and convertible securities which should benefit from increasing interest rates over the coming weeks and months.
The fund in question is the Cohen & Steers Select Preferred & Income Fund (NYSE:PSF). The fund invests in preferred securities and income producing securities, mainly in the US, but occasionally outside the US as well. Currently the fund pays roughly 8.25% in dividends in the form of monthly dividend payments.
PSF is currently trading at a discount to its NAV of nearly 7%, mainly because its share price has fallen much more quickly than its net asset value in the last month as the chart below shows.
What this chart is basically showing is that in the haste to get out of anything and everything income-oriented, investors have sold off PSF's underlying assets, but they have sold off PSF even more quickly (perhaps because of its greater levels of liquidity in PSF itself). Regardless, this situation is unlikely to be sustained in the long run, and if history is any guide, it's likely that a sharp rise in PSF's price to bring it back in line with NAV in the next few weeks.
One reason the sell-off in PSF makes so little sense is that the fund holds a fairly large (~10-20% of portfolio) amount of floating rate debt from solid credit issuers like JPMorgan (NYSE:JPM). This debt of course will appreciate as rates rise helping to offset any decrease in the value of PSF's fixed-rate preferred securities. Further, while PSF does use leverage to enhance their returns (~28% leveraged), and this leverage is borrowed at floating rates, the firm has also entered into floating for fixed interest rate swaps, effectively turning their leverage into fixed rate debt.
What's more, many of the large fixed-rate positions held by PSF are convertible securities. These securities enable the holder to swap their preferred shares for common shares, which becomes desirable if the common shares rise fast enough. For example, PSF holds (or held as of their last filing) Bank of America (NYSE:BAC) convertible notes. Now given that banks do better when the economy does better, and the Fed will only allow interest rates to rise if the economy is doing better, it follows that as interest rates rise, BofA common stock should become more valuable. This in turn means that as interest rates rise, these convertible securities should become more valuable, again offsetting the deleterious effects of rising rates on PSF's fixed income holdings.
Given these facts, it should not be surprising that even though treasury rates surged over the last five days, the fund's NAV has barely budged as the chart below demonstrates.
Now while PSF's portfolio seems very well prepared for rising rates, there are undoubtedly other CEFs out there that are equally well prepared. For example, senior bank loans are often floating rate, which will help funds like (NYSE:EFT) and (NYSE:EFR) which primarily hold these floating rate bank loans. But what makes PSF so attractive is its large discount to NAV. This ~7% discount may not seem like a lot, but compared with PSF's historical discount it actually is quite tremendous. The chart below shows this by tracking the NAV premium or discount for the fund since its inception a few years ago.
What this is showing is that historically the level of discount PSF is trading at right now is quite rare and usually lasts for a few weeks at most. As such if the last few years of history are any guide then PSF should revert to its NAV in short order. In fact, this level of discount on NAV is 2.28 standard deviations beyond the fund's mean, implying that this type of situation occurs only about 2% of the time.
In summary, given this historically large discount and the underlying strength in PSF's portfolio, the CEF stands out as very attractive at these levels.
Note: Alternative investment strategies to deal with changing rates while generating tax-exempt income, are discussed in the article here.)
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PSF over the next 72 hours. 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.