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Summary

  • The current weighted average duration of 4.32 offers some protection from interest rate risk.
  • The distribution rate of 8.3% looks well covered and sustainable.
  • The current discount of 10.36% offers an interesting investment opportunity.

Overview:

The First Trust Intermediate Duration Preferred & Income Fund (NYSE:FPF) was launched May 24th 2013. FPF is a closed end fund that invests in preferred stocks. Preferred stocks offer an attractive pick up in income above treasuries but investors have been avoiding them due to concerns over higher interest rates. Many preferred stocks are either perpetual or have very long dated maturities increasing the principal risk if interest rates rise. This perceived risk has caused many preferred stock CEFs to trade at wide discounts to NAV. FPF manages its duration exposure to limit interest rate risk by using derivatives and investing in fixed to floating rate preferred stocks. FPF also primarily invests in investment grade securities. These factors combined with the current 10.36% discount to NAV and 8.31% distribution create an interesting investment option in this yield starved environment.

Key Investment Highlights:

  • Discount to NAV: FPF is trading at a 10.36% discount to NAV. The discount is wider than the 9.23% 52 week average, generating a z-statistic of -0.72. The discount seems to be driven by an investor disinterest in preferred stock funds which could be creating an opportunity across the group.
  • High Current Distribution: FPF currently offers an 8.31% distribution. Based on the most recent report the distribution is covered by investment income and FPF has $0.2214 of UNII. It looks like the distribution is sustainable and extra income could be paid out at the end of the year.
  • Duration Management: FPF targets a duration between three and eight years, excluding the effects of leverage. As of 6/30/2014, the weighted average duration was 4.32. This relatively low duration has held back the fund's performance but should help protect value if interest rates rise.
  • Credit Quality: On average, the fund's portfolio is expected to maintain an investment grade rating. The fund is allowed to hold securities below investment grade but the average rating will be investment quality.
  • Global Diversity: FPF has a globally diverse portfolio with only 51% of holdings based in the United States. A significant amount of the portfolio is invested in European holdings where the interest rate outlook is different than in the United States.

Key Investment Risks:

  • Concentration in Financial Sector: 89% of the portfolio is held in securities from the financial sector. This isn't too surprising as the financial sector is one of the largest issuers of preferred stocks. Financial institutions have improved their balance sheets and regulators have increased capital requirements reducing some of the risk. However, if there is another banking crisis, this amount of exposure to financial institutions would be a major concern.
  • Default Risk: 34% of FPF's holdings are rated below investment grade or unrated. These securities have a higher risk of default and loss of principal. Another factor that increases the risk is preferred stock's position in the capital structure behind bonds. If a company were to default, bond holders would have to be paid before preferred stock holders would recover their principal.
  • Interest Rate Risk: FPF's portfolio has a weighted average duration of 4.32. The duration is relatively short, but if interest rates increase substantially it could have a meaningful negative effect on the portfolio's value. Also, the use of leverage in the portfolio could increase the overall duration of the fund.

Key Portfolio Metrics:

  • Premium/Discount: -10.36%
  • Z-Statistic -0.72
  • Market Distribution Rate: 8.31%
  • Current Monthly Distribution: $0.1525
  • Average Earnings/Share: $0.1594
  • Average Earnings/Distribution: 104.5%
  • UNII Per Share: $0.2214
  • Effective Leverage: 31.11%
  • Weighted Average Duration: 4.32

Performance:

Using ETFs with a similar investment objective can give a good comparison to evaluate management's performance. FPF's short history and global nature make it difficult to evaluate performance. The iShares US Preferred Stock ETF (NYSEARCA:PFF) looks like the most used ETF to add preferred stocks to a portfolio and offers an appropriate performance hurdle. FPF has shown strong relative performance, outperforming PFF over all time periods reviewed.

Data as of 7/31/2014 Source: Morningstar

Premium/Discount:

(click to enlarge)

Source: CEFConnect

The fund closed 8/20/2014 at a 10.36% discount to the NAV, or underlying value of the portfolio. This is below the 52 week average discount of 9.23%. Bad timing for the launch of the fund and concerns about higher interest rates have contributed to the discount. The short duration, high yield, and investment grade portfolio should help the discount narrow once preferred stocks return to favor.

Expense Ratio:

FPF pays 0.85% of daily managed assets to First Trust as an investment advisory fee. Stonebridge, the fund's sub-advisor and a majority owned affiliate of First Trust receives a portfolio management fee of 0.425%. Stonebridge's fee is included in the investment advisory fee paid to First Trust. The fund also pays an administrative fee and trustee fees. These fees totaled 0.08% of managed assets as of 4/30/2014. The fund also pays interest expense on the leverage employed. The annual expense ratio for FPF was 1.71% as of 4/30/2014. This fee is pretty high, but a large part of it is due to leverage. It is important to note that exposure to preferred stocks isn't cheap with ETFs charging close to 0.50% for exposure to preferred shares.

Distribution:

FPF pays a monthly distribution of $0.1525/share. This equates to an annual distribution yield of 8.31% based on current market prices. The distribution is 7.43% based on NAV. The fund is over earning its distribution and has $0.2214 of UNII/share indicating the distribution should be sustainable.

Leverage:

FPF employs leverage through a $725 million credit facility from Bank of America Merrill Lynch. The borrowing rate for the facility was 1-month LIBOR plus 0.70%. The facility also has a 0.25% commitment fee if the loan outstanding is less than 20% of the total available. For the six months ended 4/30/2014 the cost of leverage was 0.86%. As of 8/20/2014 the fund was 31.11% levered. The use of leverage can increase the volatility of the portfolio.

Liquidity:

FPF is a large CEF with $2.17 billion in managed assets. Trading volume is also respectable with 229,000 shares traded on average. This represents $4.9 million in daily volume at current prices. This is significant liquidity for a CEF and should allow investors to fill orders without problems. It is always wise to use limit orders to purchase or sell shares of closed-end funds, as the bid/ask spread can be wide.

Management:

FPF is administered by First Trust, a well know CEF, ETF, and Unit Trust sponsor. The fund is sub-advised by Stonebridge Advisors LLC, a firm that specializes in preferred stocks. Stonebridge is majority owned by First Trust.

Portfolio:

Geographic Allocation

Source: First Trust as of 6/30/2014

FPF has broad geographic exposure with only 51% of assets invested in United States based firms. The rest of the assets are spread around the globe. There is significant exposure to Europe in the portfolio. The European exposure increases the risk as Europe still faces recession. However, there could also be some benefit from the European exposure as interest rates in Europe are expected to continue falling, which could benefit the fund's holdings.

Sector Allocation

Source: First Trust as of 6/30/2014

FPF has a large exposure to banks and other financial institutions. This is not really a surprise as companies in the financial sector are the top issuers of preferred stocks. The financial exposure is an area to monitor closely as a financial collapse like 2008 would devastate the portfolio. However, financial institutions seem to be in much better shape today. Companies do not want to relive the crisis and regulators have required higher capital levels. These constraints should help limit risk going forward.

Credit Ratings

Source: First Trust as of 6/30/2014

The majority of the portfolio is invested in investment grade securities. The investment grade portfolio should provide some security if the economy stumbles.

Security Type Breakdown

Source: First Trust as of 6/30/2014

75% of the portfolio is made up of fixed to floating rate securities. These are securities that pay a fixed rate upfront and then convert to a floating rate in the future. This use of fixed to floating rate securities mitigates the risk of rising interest rates going forward. If interest rates rise, the securities payout will rise as well. However, this strategy could backfire if interest rates don't rise. Often the floating rates are LIBOR based and at current LIBOR rates the floating rate payment would be lower than the current fixed rate.

Top 10 Holdings

Source: First Trust as of 6/30/2014

FPF has a diverse portfolio with 202 total securities. The top ten holdings only represent 15.83% of the portfolio. Turnover has been low with a 20% turnover as of 4/30/2014.

Strategy:

FPF's primary investment objective is to seek high current income with a secondary objective to seek capital appreciation. The fund will look to keep duration between three and eight years excluding the effects of leverage. The fund will invest at least 80% of the portfolio in preferred and other income producing securities. While FPF may invest in securities rated below investment grade, the fund will look to maintain an average weighting of investment grade quality. At least 25% of the fund is expected to be invested in the financial sector.

Tax Issues:

As of April 30, 2014 the fund had 37,564,920 of unrealized gains on the portfolio. These are somewhat offset by 7,133,856 of tax loss carry forwards the fund reported on October 31, 2013.

Conclusion:

Preferred stocks have been out of favor due to the perception that they have higher interest rate risk. FPF was launched just as preferred stocks and other income producing securities were losing value due to QE taper talks. FPF has a shorter duration that should help protect the value of the fund if interest rates rise. The investment case is bolstered by the investment grade portfolio. FPF offers an 8.31% distribution that appears to be well covered. The current discount of 10.36% appears to offer an attractive opportunity to purchase shares.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: This Managed Duration Preferred CEF Has An 8.3% Distribution At A 10% Discount