- Preferred shares are a key asset class for an income portfolio.
- Leverage and interest-rate hedges can, in an able manager's hands, drive optimal performance from preferred shares.
- This closed-end fund, which holds primarily investment-grade securities, is currently bargain-priced, pays a 8.5% distribution, and has been a category leader in total performance for a decade.
I've been working on an exercise to construct a double-digit income portfolio. The goal is to generate income in excess of 10% with a reasonable degree of confidence for modest capital growth at the portfolio level. In doing so, I started with three names from a recent series on double-digit yield positions (here, here and here) and added some of my favorite closed-end funds that yield in the high single-digit range. Then I started looking for candidates to fill out the portfolio. One of the things I wanted to add was a good fund for preferred stocks. I'm hoping to have the portfolio article ready to submit over the weekend, but in the meantime I thought it was worth a quick note on the preferred stock fund that rose to the top of my queries as it may just be a bit of a bargain at the moment.
Flaherty & Crumrine Preferred Securities Income (NYSE:FFC) is a fund I have held in the past but haven't looked at recently. The fund is 11 years old, holds total assets just shy of $1.3B and carries a Morningstar Silver rating. As of July 31, 2014, the fund has 94% of its portfolio invested in preferred stocks and 5% in long-term debt. These numbers can change to as low as 80% preferreds depending on the hedging strategies the managers deem appropriate. The fund carries 33% leverage funded with senior long-term debt. Leverage is relatively high for its peer group surpassing two-thirds of preferred stock CEFs. The fund must maintain at least 80% of its holdings in investment-grade securities. <Added on edit, 30 Aug 2014: 50% of the fund's income was listed as qualified dividends for 2013.>
FFC's current distribution rate of 8.5% (8.25% on NAV) is supported by a 1-year return on NAV of 18.9% (source: cefconnect).
Total returns have been impressive over the life of the fund as seen in this table from the sponsor's website:
Note that for recent time periods market returns fall below NAV returns, sometimes substantially so. This is a consequence of the fund typically selling at a premium to its NAV.
The power of the 33% leverage can be seen in a comparison of FCC with the largest preferred-stock ETF, iShares S&P US Preferred Stock Index Fund (NYSEARCA:PFF). Total return for the two funds is seen in the charts below. When we consider that PFF's dividend yield of 6.19% lags FCC by over 200 bps, it should be clear that active management by a team with experience in using leverage and hedges is a clear positive in this space.
And, if we look at NAV, the outperformance of FFC vs. PFF is even more extreme. As few on-line charting services list NAV tickers, I'm using Yahoo Finance for the NAV ticker (XFFCX, the green line in the charts). Unfortunately, Yahoo does not provide a total-return chart, so these charts represent price only. When reviewing them, keep in mind that not only does FFC outperform on market and NAV bases, it also has a substantially higher distribution yield.
Note that the fund's poorest performance on market price was for the last half of 2013, which was marked by a massive sell-off of interest-rate sensitive funds, the so-called "taper tantrum." NAV performance, by contrast, maintained a reasonable pace, falling no more than the unleveraged ETF while returning substantially higher distributions.
As with all fixed-income asset classes, preferred stocks are sensitive to rising interest rates. FFC's managers use a hedging strategy to provide some protection against increases in interest rates, although the managers do indicate that traditional hedging vehicles are becoming less effective and more expensive in this extreme environment for debt and credit investing. This is an area where effective management is especially significant. Flaherty & Crumrine has extensive experience in the preferred stock arena having been successfully operating hedged and leveraged preferred stock closed-end funds since 1991. This wealth of experience helps generate a level of confidence in their ability to work effectively in a rising-rate environment. The company manages several strong preferred-stock funds and is widely considered to be a leading fund sponsor in the category.
The really interesting thing about FCC today is its discount of -3.24%, a level not seen since the "taper tantrum" of 2013, and before that the recession years. CefAnalyzer notes Z-score below -1 for all time periods it reports with the exception of 1 year at -0.93:
See here for an explanation of Z-scores if the concept is new to you.
Given Flaherty & Crumrine's strength as a long-time leading fund in the preferred stocks asset class, an interested investor might also want to look at their other offerings as well. Flaherty & Crumrine Dynamic Preferred & Income Fund (NYSE:DFP) is a newer fund (inception date: 24 May 2013). It is about half the size of FFC (AUM $695M) and carries 32% leverage. The fund pays a distribution of 8.41% (7.70% on NAV) supported by 1-year return on NAV at 20.67%. DFP currently sports a -8.50% discount, close to its 52-week average of -8.30%.
My research indicates to me that FFC and DFP are the top choices in preferred stock CEFs at this time. Of the two, I prefer FFC for its longer track record of solid performance. It also offers the investor a slightly higher distribution rate at market price. FFC's distribution is appreciably higher at NAV which is, of course, a better indicator of the fund's management than market-based yield. Moreover, I think the current discount, while less attractive on the surface than that of DFP's deeper discount, is, in my view, more likely to see a reversion to its mean of premium valuations.
Why Invest in an Expensive Closed-End Fund?
The edge over an ETF is obvious from the charts above. But what about doing it yourself? Preferred stocks is a category where I consider one can do much better by investing in a well-managed closed-end fund than doing it on one's own. CEF managers have the power of leverage working for them and the best have an understanding of hedging strategies that few individual investors have, and even fewer can use effectively. For this reason I consider FFC's fees of 1.84% (baseline fee at 1.20% plus 0.64% interest expenses) to be a reasonable cost for access to the expertise of the fund's management team.
What does one get for that 1.84%? Exposure to a portfolio of investment-grade preferred shares that is yielding over 8% with a history of solid capital appreciation over all recent time periods. I would submit that a typical individual investing in preferred shares, even one with a fair level of sophisticated knowledge of this specialized market niche, would will likely be generating returns more like PFF's than FFC's: Yields in the mid-6% range and solid capital preservation with little, if any, real growth. Those that are achieving higher yields will be doing so by moving to preferreds carrying significantly higher credit risk and even then are unlikely to be generating 8.5% in income across the whole portfolio.
My choice for exposure to the preferred-stock asset class at the moment is certainly FFC. I'll be looking at it carefully as I consider filling this hole in my income portfolio.
Finally, as always I remind readers that this article does not constitute investment advice. I am passing along the results of my research on the subject. Any investor who finds FFC intriguing will certainly want to do all due diligence to determine if the fund is suitable for his or her portfolio. As always I welcome your comments and critiques, particularly from those readers who have contrary opinions.