A reader recently suggested I look at John Hancock Premium Dividend Fund (NYSE:PDT) in a comment on an article about a different closed-end fund, or CEF, Calamos Convertible Opportunities & Income Fund (NASDAQ:CHI). Although the core of the two funds is kind of apples to oranges, that doesn't mean that PDT isn't a fund worth a deeper dive. In fact, if you are looking for a steady income stream from a relatively boring investment, PDT might be a good choice for you.
What's it do?
PDT is something of a hybrid fund, investing in preferred stocks and equities. At the start of the year, preferred stocks made up around 70% of the portfolio and equities around 30%. Since preferred stocks are in some ways very similar to bonds, this is a pretty conservative stance. There is no stated objective for how much should be in each of these groups; however, dividend-paying investments must make up at least 80% of the portfolio, and at least 25% of the portfolio must be invested in the utility sector.
All of this makes sense given the fund's objective of high current income and modest growth of capital. That said, at the start of the year, utilities made up more than the target, at around 45% of the portfolio. Financials, meanwhile, chimed in at 40%. There is no target for the financial sector, but when it comes to preferred stocks, the financial sector is one of the larger issuers. So the heavy exposure there is most likely a function of necessity. But suffice to say, this isn't just a preferred fund, it's more like a preferred utility and financials fund.
This isn't bad, it's just something you need to understand as you look at the fund and its performance. But don't get caught up in the negatives associated with financials, because the 2007 to 2009 financial-led recession actually showed PDT's strength. The fund fell nearly 22% in 2008, far less than the SPDR S&P 500 ETF (NYSEARCA:SPY) and, perhaps more impressively, less half as much as the Financial Select Sector SPDR Fund's (NYSEARCA:XLF) painful 55% decline. There were likely two broad reasons for that: the fund's utility investments offset some of the financial sector's decline and preferreds are higher up in the capital structure than equities and have bond-like features, so they tend to hold up reasonably well in bad times.
This is backed up by the fund's standard deviation, a measure of volatility. Over the trailing 15 years through December, PDT's standard deviation was around 12. SPY's standard deviation was around 15. But here's the interesting thing: PDT's annualized total return over that span, which includes the reinvestment of distributions, was roughly 8.5%. SPY's return? A far less notable 5% or so.
To be fair, that's not a great comparison point because SPY and PDT are very different investments. However, the ability to get equity-like returns (better over this period) with less risk is fairly enticing. But there is a risk here that's worth paying attention to: the fund can use leverage. At the end of its October fiscal year, leverage stood at around 33% of the fund. Leverage can enhance returns in good years, but can also lead to worse returns in bad years. So far, though, the fund appears to have handled this risk pretty well. So leverage is something to be aware of, but not necessarily something to be scared of.
A little different today
At this point, however, PDT is a bit different than it was dividend wise. Specifically, in late 2014, the fund shifted to a managed distribution policy whereby it pays $0.09 a share every month in distributions. Based on a combination of income and capital gains, that's a pretty comfortable sum and amounts to a reasonable distribution yield of around 8.5%. The yield based on NAV is closer to 7.5% given the around 12% discount at which the fund has recently been trading.
That discount, by the way, is notably larger than the fund's trailing five-year average discount of 7%, according to the Closed-End Fund Association. The 10-year average discount is closer to 10%, so it's relatively cheap compared to that period, too, but not by as much. So now could be a good time to take a look, a fact that the fund's bear market performance suggests might be doubly true, now that the markets are bit skittish.
One thing to keep in mind, however, is that the fund's distribution is going to account for most of your return. If you live off the income, your performance isn't going to match up to the fund's total return. Moreover, the fund's distributions are different today than they have been in the recent past. For example, distributions were lower between fiscal 2011 and fiscal 2013. They jumped in fiscal 2014, a year with notable capital gains, and have now settled into a consistent monthly pattern.
But up until the managed payout, the distribution pretty much moved in line with what the fund could pay out of interest income and capital gains. That's not the same today, so a tough market could leave PDT dipping into capital to maintain the steady monthly distribution. That's not something to worry too much over, but it is something to watch.
The other fly in the ointment here is cost. The fund's expense ratio is a fairly high 1.85%. This, however, has a lot to do with the fund's use of leverage. And, so far anyway, leverage appears to have been a net benefit relative to the cost.
Worth a look
Summing it all up, I'd say that this fund is clearly worth a look for investors seeking income and stability. The yield is at a reasonable level, historical performance has been solid, and risk has been subdued relative to the broader equity market. And with an around 12% discount to NAV, now could be an opportune time to buy in.
Disclosure: I am/we are long CHI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.