Recently I have wriiten a couple of articles on preferred stocks (links at the end of the article) and thought that it might be worthwhile profiling a closed end fund that could allow an investor to buy a managed portfolio of preferred stocks. I will address Flaherty and Crumrine's CEF Preferred Income Opportunity Fund (PFO), a $176MM portfolio of assets. My choice for this first piece on preferred CEFs was based on my knowledge of Flaherty and Crumrine (I have known Don Crumrine and his team for many years, and think very highly of them) and their superb reputation within the preferred industry. Note all portfolio data is as of 11/30/2011.
Flaherty & Crumrine Preferred Income Opportunity Fund was incorporated as a Maryland corporation on December 10, 1991, and commenced operations on February 13, 1992. The Fund's investment objective is to provide its common shareholders with high current income consistent with the preservation of capital.
It is important when analyzing a CEF to get a feel for the investment portfolio in order to ensure there is no overwhelming exposure to one industry, as a balanced industry exposure should lead to more stable returns over time.
Source: company reports.
As we can see, the fund is not significantly weighted to any one industry. Interestingly, the fund has a 27% exposure to utilities, which adds to the stability of returns. I wrote an article on my top picks in utility preferreds as I believe the inclusion of utility preferreds in a preferred/income portfolio helps reduce volatility and stabilize returns.
Next, we have to get a feel for the funds top ten holdings as they will help drive the funds returns:
Source: company reports
While the majority of the funds top holdings are financial in nature, this is consistent with the preferred market. You will notice that the fnancials include global banks and insurance companies as well as utilities and energy companies. Recently, the fund changed its investment parameters to allow it to invest in lower rated securities. The impact of the changes are summarized below:
Impact of Changes
- Fitch is now one of the approved ratings agencies for determining whether a security meets the definition of "investment grade" for purposes of the Fund's policy of investing at least 75% of its assets in securities rated investment grade at the time of purchase or in securities of equivalent quality;
- The Fund may now purchase securities rated below Ba3/BB-/BB- by each of Moody's, S&P and Fitch, respectively, as long as the senior debt of the same issuer is rated investment grade by any one of Moody's, S&P or Fitch at the time of purchase; and
- If the senior debt of an issuer is unrated or it has no outstanding senior debt, the Fund may now purchase its preferred securities if they are rated at least Ba3/BB-/BB- by any one of Moody's, S&P or Fitch, respectively.
Keep in mind that the Fund will apply the ratings criteria at the time of purchase and the Fund will not be required to dispose of securities if, after purchase, they are downgraded, although the adviser may take this into account in determining whether to retain the security. As a result, more than 25% of the Fund's holdings at any time may be rated below investment grade or in equivalent securities.
With this in mind, lets look at the ratings profile of the fund:
Although the company can go deep into high yield space, the manager has chosen not to at this juncture. This alludes to a conservative portfolio profile. In addition to below investment grade, The Fund may invest up to 15% of its assets in common stocks and, under normal market conditions, up to 20% of its assets in debt securities.
It is also important to understand that the fund utilizes leverage to increase the income of the portfolio and, therefore, potential distributions to shareholders. The fund is currently using $62.5MM of loans to increase returns. Use of leverage is an important part of the Fund's strategy to produce high current income, because, over time, the cost of leverage typically is lower than the yield on the Fund's portfolio. The difference between what the Fund earns on its investments and pays on the money it borrows increases the income available to common shareholders.
This past year, leverage has had a particularly meaningful impact on the Fund's distributions. First, the Fund twice lowered the rate it paid for leverage, and for the fiscal year paid a weighted-average interest rate of 1.202% on its borrowed money (versus much higher current yields generated by the Fund's portfolio). Second, as the Fund's net asset value improved during the year, the Fund was able to increase the amount of leverage employed. One additional benefit of the fund is the current tax breaks afforded qualified dividend income (although it is supposed to sunset at the end of this year).
In 2011, the Fund passed on a portion of its income to individuals in the form of qualified dividend income or QDI. Under federal law, QDI is taxed at a maximum 15% rate instead of an individual's ordinary income
tax rate. In calendar year 2011, approximately 52.4% of distributions made by the Fund was eligible for QDI treatment. For an individual in the 28% marginal tax bracket, this means that the Fund's total distributions will only be taxed at a blended 21.2% rate versus the 28% rate which would apply to distributions by a fund containing traditional corporate bonds.
Thus far we have seen that the fund is diversified in terms of both sectors, ratings and top holdings. These features should allow the fund to generate stable total returns (and hence dividends) for investors.
Returns have been strong over time and have outperformed both the S&P (yes, I understand the impact of 2007-2008) and the iShares Preferred Stock Index Fund (PFF).
The fund currently trades at a premium of 17% to NAV, which is higher than its historic level and which I would attribute to the search for yield. This makes me somewhat nervous, and I would prefer to commit further capital to the fund at less of a premium. The yield on the fund is currently 7.63%, which, in my opinion, is a more than adequate yield for the portfolio.
I continue to be a buyer of PFO for both the capital appreciation potential as well as the income generation ability of the fund, but will wait to see if the premium comes down some.