Before I begin my analysis of the Flaherty & Crumrine preferred closed end funds, I would like to explain what I am going to do with this series of analyses.
At one point in my career, I worked for an investment consulting firm, where I was the Director of Fixed Income Research. Essentially, what I was responsible for was analyzing managers and recommending managers for our clients' (pensions, endowments, foundations...) fixed income mandates. The analysis and recomendations were based on:
- Management team,
- Manager style,
- Manager returns, and
- Fund/portfolio client fit
The is what I am planning for the series: I am going to review three managers' preferred closed end fund complexes (one manager per article) and recommend one fund per manager. The fourth complex will be recommendations from readers/commentors (I will pick the four most recommended/popular funds picked by the readers). The fifth article in the series will be the showdown between the top four picks. Essentially, I am trying to bring institutional manager selection to Seeking Alpha readers. Hopefully this will be very interactive. All information and data contained in this report is from company reports and filings, CEFA and Morningstar.
Management team: Flaherty and Crumrine is an investment adviser specializing in the management of preferred securities. Founded in 1983, our historic knowledge and dedicated credit research capabilities have allowed us to provide clients with the individualized attention needed to withstand dynamic markets. With an eye towards the long-term, we are committed to helping our clients navigate intricate preferred securities markets. For individuals, we offer a family of five closed-end funds which invest primarily in preferred securities. For institutional accounts, we offer customized preferred securities portfolio strategies to best meet each client's particular investment objectives, risk tolerances, tax position and time horizon. (from the manager's website here: Flaherty & Crumrine Homepage)
The funds managed by Flaherty and Crumrine that will be analyzed are:
- Flaherty & Crumrine Preferred Income Fund (NYSE:PFD)
- Flaherty & Crumrine Preferred Income Opportunity Fund (NYSE:PFO)
- Flaherty & Crumrine/Claymore Total Return Fund (NYSE:FLC)
- Flaherty & Crumrine/Claymore Preferred Securities Income Fund (NYSE:FFC)
An overview of the funds is as follows:
click to enlarge
Manager style: Manager style in a preferred CEF context can be somewhat determined by portfolio concentration, sector allocation and portfolio turnover.
Portfolio concentration - Ideally, if an investor wants a stable return (payout) portfolio, the manager should not have overly concentrated positions (or sectors to be addressed next). A review of the top ten holdings should give us a feel for the concentration of the portfolio. What we are going to look for is positions greater than 5-10% and significant sector concentration within the top ten holdings. Let's take a look:
Reviewing Flaherty's various portfolios does not reveal overly concentrated positions (highest is 5.4%) and the top ten holding max at 36.2%. This should help manage volatility and swings in the portfolios as there is not a significantly concentrated portfolio. One other thing to notice is how the top ten holdings across portfolios are very similar, which tells me the portfolios are managed similarly and should all perform in a similar manner.
Sector allocation - Part of a manager's style can be determined by their sector distribution. If a fund/portfolio is too focused in any one sector, the manager is making a "bet" on the sector and returns can be volatile. For our purpose, we desire a portfolio that is diversified among sectors and has stable constituents as well as higher beta constituents. Let's have a look:
As we can see from the above table, all the funds are roughly in-line with each other and are well diversified amongst sectors (banks, insurance and finance make up the lions share of the preferred market, F&C has, by mandate, a higher exposure to the more stable utilities.
Portfolio turnover - A manager's style can often be viewed as a "closet benchmarker" or an "active manager". A benchmarker will often "set it and forget it" and have very low portfolio turnover, whereas an active manager will have a greater turnover as they attempt to optimize their portfolio. Let's see where Flaherty falls:
While the various funds' turnover rate has fallen since the credit crisis, I would view Flaherty as an active manager. I would also expect the turnover rate to increase with the increased activity in the preferred capital markets.
Ratings - Often, a style change by management can be seen by a change in the ratings profile of the portfolio. This can be the result of a manager jumping into ratings momentum (playing HY versus IG) or reaching for the additional yield available in lower rated securities. Let's have a look:
As we can see by the above tables, ratings have remained consistent over the last year, with the exception of FFC, where the portfolio has been brought more in line with the rest of the complex. Of note is the more "barbelled" strategy of FLC and FFC, where they have a higher IG component as well as a higher below BB component. I do not view these changes as a change in strategy and the manager appears to have a consistent ratings preference.
Realize that during 2011, the funds went through a policy change that will allowthem to have a higher percentage of high yield issues. The policy change is stated below (from the funds annual N-CSR):
Old Policy: At time of purchase, at least (75% PFD and PFO) and (80% FFC and FLC) of the securities that the Fund will acquire will be rated investment grade by either Moody's Investors Services, Inc. or Standard & Poor's Corporation, or, if unrated, judged to be comparable in quality. In addition, the Fund may invest up to 25% of its assets at the time of purchase in securities rated below investment grade by both Moody's and S&P, if (A) such securities are rated at least "Ba3" by Moody's or "BB-" by S&P and (B) such securities are issued by an issuer having an outstanding class of senior debt rated investment grade at the time of purchase. Thus, the Fund may not invest in securities rated below "Ba3" by Moody's and below "BB-" by S&P.
New Policy: At time of purchase, at least (75% PFD and PFO) and (80% FFC and FLC) of the securities that the Fund will acquire will be rated investment grade by any one of Moody's, S&P or Fitch Ratings Group ("Fitch"). In addition, the Fund may invest up to 25% of its assets at the time of purchase in securities rated below investment grade by all of Moody's, S&P and Fitch, provided that such securities are rated at least "Ba3" by Moody's, "BB-" by S&P, or "BB-" by Fitch or such securities are issued by an issuer having an outstanding class of senior debt rated investment grade by any one of Moody's, S&P, or Fitch at the time of purchase. Thus, the Fund may invest in securities rated below "Ba3" by Moody's, "BB-" by S&P and "BB-" by Fitch if the issuer has investment grade senior debt outstanding.
It comes down to the change between "and" and "or" in the policy (in addition to including Fitch). I view this as a result of the multiple notching of preferreds within the banking sector and not just a "go hog wild" with high yield.
Returns are the easiest aspect of our analysis as they are the result of all the factors analyzed.
One thing that is obvious from the return table above is that preferred stocks are not exempt from the wild swings of a distressed (2008) - or exuberent (2009) - market. Due to the financial exposure of preferreds, 2008 was a brutal year and 2009 was joyous. I expect returns to be more consistent with their 5 year averages if not a little below.
Fund/protfolio client fit:
This analysis was done with a client interested in high current income with capital preservation in mind. All the funds reviewed would be consistent with this mandate, but an emphasis has to be placed on those funds trading closer to their historical premium (discount) as "premium evaporation" could have a significant effect on capital preservation. Normally, I would also place an emphasis on those funds with the greatest tax advantaged component of the distribution (the QDI or qualified dividend income component for individuals and DRD or dividend received deduction for corporations). Due to the sunsetting of this tax provision at the end of this year (as it currently stands), I have looked at it (see below) but did not place an undue amount of emphasis on it.
Until the tax provision sunsets, PFD and PFO have clear tax advantages. Unfortunately, they also trade at the highest premium to NAV at 25% and 22%, respectively.
When I review all the information presented above, I arrive at the following conclusion: The funds are homogenous and have very similar attributes, the manager's style seems consistent among funds (now that FFC is more in-line) and liquidity is available across funds so my choice will primarilly be a factor of distribution yield and premium (discount).
As a result of the above analysis, my top pick from the Flaherty and Crumrine preferred CEF complex is Flaherty & Crumrine/Claymore Preferred Securities Income Fund . The fund, in my opinion, has a conservative portfolio profile, a reasonable premium and a decent distribution rate.
The funds annual reports (form N-CSR) can be found here:
Preferred Income Fund
Preferred Income Opportunity Fund
Flaherty & Crumrine/Claymore Preferred Securities Income Fund
Flaherty & Crumrine/Claymore Total Return Fund Incorporated