As a retiree, I am always looking for income opportunities that are relatively low risk. Preferred stocks Closed End Funds (CEFs) are often overlooked by investors and have the potential for higher income than common stock funds. Like common stocks, most preferred stocks bottomed in March of 2009 and have recovered nicely. Many of the CEFs were selling at a premium to Net Asset Value (NAV) until June of this year, when fear of rising rates precipitated another selloff. As a result of this decline, many of the CEFs are now selling at a discount. Considering that many of the CEFs offer high income (on the order of 7% to 8%), I decided to asses this asset class for candidates to include in a retirement portfolio. This article will review the risk versus reward over several time periods and will also touch on some issues that could affect the CEFs in the future.
First let's take a quick review of the characteristics of preferred stocks. Many companies issue preferred stock since this is one way corporations can raise money without diluting the number of common shares. Preferred stock does not have voting rights but usually has a much higher dividend than the common stock. The dividend payment associated with preferred stock is not guaranteed but the preferred stock holder must be paid before the common stock holder can receive any dividends. Thus, preferred stock sits between bonds and common stock in the capital structure. It is senior to the common stock but will be paid after the interest on bonds. Suspending payments on preferred stock is a last resort but it is not considered a default like suspending payment to bondholders.
After issuing a preferred stock, the price can fluctuate, with one of the key factors being interest rates. If interest rates rise, then the price of the preferred shares will likely drop because investors will demand higher yields. Also, like a bond, many of the preferred stock issues are callable at a specified date in the future.
There are several closed end funds that invest primarily in preferred shares. Using data from CEFConnect.com, I selected candidates based on the following criteria:
- I wanted to analyze CEFs over a complete bear and bull market cycle, so I chose CEFs that had a history going back to 12 October, 2007 (the start of the 2008 bear market)
- Distributions had to be at least 6%
- Premiums had to be less than 5%
- Market Cap had to be greater than $200M
- Average trading volume had to be greater than 50,000 shares per day
The following CEFs satisfied all of these conditions:
- Flaherty & Crumrine Preferred Securities Income (FFC). This CEF has a distribution of 8.8% and sells for a small discount of 0.5%. It has typically sold at an average premium of over 4% over the past 52 weeks. The fund was launched 10 years ago and has a good long-term track record. Despite its high distribution, it has used return of capital (ROC) in only one year since inception. The fund's portfolio consists of 134 holdings, concentrated primarily in stocks of banks, insurance companies, and utilities. It utilizes 34% leverage and has an expense ratio (including interest payments) of 1.6%.
- John Hancock (JH) Preferred Income III (HPS). This CEF has a distribution of 8.3% and is selling at a discount of 1.6% (compared to a 52 week average premium of 1%). The fund has 103 holdings focused mainly on utilities and banks, with about 80% being US based. It had some destructive ROC during the bear market of 2008 but generally has generated sufficient earnings to cover distributions. It utilizes 33% leverage and has an expense ratio, including interest payments, of 1.7%. Note that two additional preferred stock CEFs are in John Hancock family: JH Preferred Income (HPI) and JH Preferred Income II (HPF). These sister funds have similar portfolios and are highly correlated with one another. Therefore, I only included HPS in my analysis since it was the most liquid.
- John Hancock Premium Dividend Fund (PDT). This John Hancock fund is more diversified than the pure preferred stock funds in the JH family. PDT consists of about 60% preferred stock and the rest is in dividend-paying equities. It is selling at a large discount of over 10% (which is a larger discount than the average discount of 4%). The fund has a distribution of 6.9%, none of which comes from ROC. It has over 100 holdings, with the utility sector accounting for almost half of the total assets. The fund uses 33% leverage and has an expense ratio of 1.8% (including interest payments).
- Nuveen Preferred Income Opportunities (JPC). This CEF sells at a discount of 8.8% (double the average discount of 4.4%) and has a distribution of 8.1%. At the end of 2011, the fund changed its investment strategy from a multi-sector fund to a preferred stock fund. Investors should be aware of this strategy change when evaluating this fund's longer-term performance. The new strategy is generating sufficient income to cover distributions so the fund is not using ROC. The fund has 234 holdings spread among insurance companies, banks, financials, and real estate investment trusts. JPC utilizes 29% leverage and has an expense ratio of 1.8% (including interest payments).
- Nuveen Quality Preferred Income (JTP). This CEF sells at a discount of 10.6% (over three times the average discount of 3.2%) and has a distribution of 7.6%. It has 200 holding, primarily in the insurance, commercial bank, and financial sectors. It employs 29% leverage and has an expense ratio of 1.8%, including interest payments. Another sister fund, Nuveen Quality Preferred Income 2 (JPS) has a similar portfolio that is highly correlated with JTP. Therefore, JPS was not included in the analysis.
There are also preferred stock Exchange Traded Funds (ETFs). These funds differ from CEFs in that they passively track an index rather than being actively managed. Also, the ETFs do not use leverage, so typically they are less volatile and have lower expenses than their CEF counterparts. I included the largest preferred stock ETF in the analysis so I could compare the ETF performance with CEF performance. The ETF selected was:
- iShares S&P U.S. Preferred Stock Index (PFF). This ETF holds 200 preferred stocks, with about 75% being domiciled in the United States. The vast majority of the holdings are from the financial sector. The fund has a low expense ratio of 0.48% and yields 5.8%.
Since preferred stock has attributes of both bonds and stocks, I also included the following ETFs in the analysis for reference:
- SPDR S&P 500 (SPY). This ETF tracks the S&P 500 equity index and has a yield of 2%.
- iShares Barclays 20+ Year Treasury Bond (TLT). This ETF tracks the performance of long-term treasury bonds.
To analyze risks and return, I used the Smartfolio 3 program (smartfolio.com) over a complete bear-bull cycle (from 12 October 2007 to the present). The results are shown in Figure 1, which plots the rate of return in excess of the risk free rate of return (called Excess Mu on the charts) against the historical volatility.
Figure 1. Risk versus Reward over bear-bull cycle
As is evident from the figure, there was a relatively large range of returns and volatilities. For example, FFC had a high rate of return but also had a high volatility. Was the increased return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio.
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. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY. Similarly, the blue line represents the Sharpe Ratio associated with TLT.
Some interesting observations are apparent from Figure 1. Over the complete cycle, long-term bonds had the best risk-adjusted return. This is because they held up better than equities during the horrendous bear market of 2008. A couple of CEFs, DDT and FFC, had about the same Sharpe Ratio as TLT. All the preferred stock CEFs had better risk-reward performance than either SPY or PFF. Overall, the CEFs had high volatility but also delivered high performance. Based on this chart, the preferred stock CEFs would have made good additions to your portfolio.
I next looked at the past 3 year period to see if the outperformance has continued. The results are shown in Figure 2. What a difference a few years made! Over the past 3 years, the SPY has been in a rip-roaring bull market and neither preferred stock CEFs nor the bond funds could keep pace.
Figure 2. Risk versus Reward over 3 years
The data shown in Figure 2 is more aligned with expectation, as the performance of the preferred stock CEFs was between that of bonds and equities. Also evident from the figure is that the preferred stock CEFs have relatively high volatility, about the same as the SPY. On the other hand, the preferred stock ETF, PFF, had substantially lower volatility but also had a lower risk-adjusted return than the CEFs. Over this period, JPC led the pack with about the same Sharpe Ratio as the SPY. FFC was not a standout during this period but did continue to perform relatively well. The decision whether or not to invest in preferred stock CEFs was not as clear-cut as it was for the longer time period.
The investment landscape became even murkier in the recent past. Since June of this year, the fear of rising rates has taken its toll on preferred stocks, causing them to give back most of the year to date gains. To get a more near-term view, I ran the analysis from the beginning of 2012 to the present, a little over 1.5 years. This data is presented in Figure 3. The near term results are similar to the 3 year data. The performance of the preferred stock CEFs is better than long-term bonds but worse than the S&P 500. The volatility of these CEFs is on the same order as the stock market.
Figure 3. Risk versus Reward since Jan 2012
Which is better, the preferred stock ETF or the CEFs? As you have seen, it depends on the time period under analysis. Over the longer term, CEFs had better risk-adjusted performance but over the near term, PFF has a much higher Sharpe Ratio. So it really depends on the market conditions that you expect in the future.
Before leaving this analysis, there are a couple of additional factors that you should consider. In addition to interest rate risk, preferred stocks also have a re-finance risk. Since many preferred stocks are callable, the issuing company can call their preferred stock and re-issue at a lower interest rate. This is especially true in a low interest rate environment like we have had recently. In 2012, $13 billion of preferred stock was redeemed (with average coupon rate of 7.16%) and replaced with issues that had an average coupon rate of 6.37%. This puts downward pressure on preferred prices.
Also, as part of the Dodd-Frank Act, non-perpetual preferred issues can no longer be used to satisfy Tier 1 capital requirements. The banks must phase out the use of these preferred stocks by 2015 and replace them with other forms of capital. One of the nuances of the Dodd-Frank Act is that it will likely allow some bank preferred trust issues to be recalled earlier than originally planned. This too will increase the headwinds against preferred issues.
The bottom line is that preferred CEFs were once excellent candidates to add to retirement portfolios. They were always volatile but since they were relatively uncorrelated with other assets, they provided diversification as well as high income. However, in the current environment of potentially rising rates and new regulations, caution is advised. You must carefully evaluate the risk and rewards relative to your investment objectives. Using CEFs for your preferred stock exposure can be rewarding but it is not for the fainthearted.