The 'Off The Shelf' Preferred Portfolio - Part I

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Includes: DFP, FFC, PFD, PFF, PFO
by: Rubicon Associates

Summary

This is my first in a series about "off the shelf" preferred stock portfolio.

Flaherty & Crumrine manages four preferred stock focused closed end funds and is one of the few firms that are singularly focused on this market.

This analysis leads to my top pick of their funds.

The other day, I wrote a research article on preferred stocks, specifically, utilizing preferred stocks instead of high yield in an income focused portfolio. At the end of the article I stated that I would review the various preferred stock closed-end funds.

Rather than write one article focused on all of the funds, I will focus on one manager at a time and the various closed-end funds they offer. After all, in an actively managed fund, you are buying the manager. Pick the best fund by the best manager and you have a winning combination. Within the preferred stock arena, there are three primary managers:

  1. Flaherty & Crumrine,
  2. Spectrum Asset Management, and
  3. John Hancock

The focus of this research will be Flaherty & Crumrine.

Flaherty & Crumrine was formed in 1983 with the express intention of managing portfolios of preferred securities for institutional investors.

As of 2/28/15, the firm managed portfolios of preferred securities for U.S. and foreign institutions, including industrial corporations, insurance companies, nuclear decommissioning trusts, and non-profits. Their regulatory assets under management were approximately $5.1 billion. Form ADV here.

The lead portfolio managers within the firm are:

R. Eric Chadwick, CFA

Portfolio Manager and President

1/99Present Flaherty & Crumrine Incorporated

1/97 - 12/98 Koch Industries, Inc. (Portfolio Manager/FinancialAssociate)

Bradford S. Stone

Portfolio Manager, Executive Vice President and Chief FinancialOfficer

5/03 - Present Flaherty & Crumrine Incorporated

6/01 - 5/03 Barclays Capital (Director, US Market Strategy )

2/87 - 6/01 Goldman, Sachs & Company (V P, Interest RateStrategy, Executive Director, Global Hedge Fund Sales

8/83 - 2/87 Salomon Brothers Inc. (VP, Government & DerivativesSales , Associate, Options Trading Hedge Fund Sales)

The funds being reviewed are:

Flaherty & Crumrine Preferred Securities Income Fund Inc. (NYSE:FFC) is a diversified, closed-end management investment company incorporated in the USA. The Fund's investment objective is high current income for holders of its common stock consistent with preservation of capital. At least 80% of the Fund's total assets will be invested in a diversified portfolio of preferred securities. The Fund expects that its portfolio of preferred securities will consist principally of 'hybrid' or taxable preferreds. At least 80% of the Fund's preferred securities will be investment-grade quality at the time of purchase.

Flaherty & Crumrine Preferred Income Fund Inc. (NYSE:PFD) is a diversified, closed-end management investment company incorporated in the USA. The Fund's investment objective is high current income for holders of its Common Stock consistent with preservation of capital. In seeking its objectives, the Fund normally will invest at least 80% of its total assets in a diversified portfolio of preferred securities, some or all of which are expected to be hedged. The Fund may also invest up to 20% of its total assets in debt securities and up to 15% of its total assets in common stocks. At time of purchase, at least 75% of the securities that the Fund will acquire will be rated investment grade by any one of Moody's Investors Services, Inc. , Standard & Poor's Corporation or Fitch Ratings Group.

Flaherty & Crumrine Preferred Income Opportunity Fund Inc., (NYSE:PFO) is a diversified, closed-end management investment company incorporated in the USA. The Fund's investment objective is high current income for holders of its Common Stock consistent with preservation of capital. In seeking its objectives, the Fund normally will invest at least 80% of its total assets in a diversified portfolio of preferred securities, some or all of which are expected to be hedged. The Fund may also invest up to 20% of its total assets in debt securities and up to 15% of its total assets in common stocks. At time of purchase, at least 75% of the securities that the Fund will acquire will be rated investment grade by any one of Moody's Investors Services, Inc., Standard & Poor's Corporation or Fitch Ratings Group.

Flaherty & Crumrine Dynamic Preferred and Income Fund (NYSE:DFP) is a non-diversified, closed-end management investment company incorporated in the USA. The Fund's investment objective is to seek total return, with an emphasis on high current income. Under normal market conditions, the Fund invests at least 80% of its "Managed Assets" in a portfolio of preferred and other income-producing securities issued by U.S. and non-U.S. companies, including traditional preferred stock, trust preferred securities, hybrid securities that have characteristics of both equity and debt securities, convertible securities, subordinated debt, and senior debt. Within the fund, at least 80% of its Managed Assets will be in a portfolio of preferred and other income-producing securities issued by U.S. and non-U.S. companies, more than 25% of its Managed Assets will be in the financials sector and at least 80% of its Managed Assets will be in (NYSE:I) investment grade quality securities or (ii) below investment grade quality preferred or subordinated securities of companies with investment grade senior unsecured debt outstanding, in either case determined at the time of purchase

Before looking at valuation, a comparison of the four funds and more detail is in order.

In order to best do this, we will have to look at the sector and issuer exposures in order to determine the characteristics of all four funds. The more similar they are, the easier the choice becomes when selecting one.

First, a look at the sector allocation of the four funds:

As expected, bank, insurance and utilities are the primary sectors of the funds as they are the largest issuers of preferreds. In the finance sectors, they are used for capital purposes as well as long dated financing. They serve as long dated financing for the other sectors as well, so non-financials use them for liability management.

The sector exposures are very similar. PFO and PFD use different (more consolidated) sector listings, but rather than go through the holdings to create a 100% apples to apples comparison (as the position listings are stale, or at least more stale than the information presented above), I consider the variance acceptable and believe the allocations are basically in line with each other.

Next, a look at the issuer exposure of the funds. This is a long table (I apologize, but it is necessary), but will give a feel for the top ten positions of each fund.

In order to try to make it somewhat less painful, a "roll up" comparison of the funds top exposures is done:

Click to enlarge

As the above table shows, the more "traditional" preferred CEFs (FFC, PFO and PFD) have more over lapping positions than they do with the more "dynamic" (preferred and fixed income) DFP. The largest positions are JPMorgan and Liberty Mutual (all of the top ten are solid issuers, giving comfort in this fact).

Now that we have seen that the funds are similar (DFP being somewhat different, however), a look at the funds from a "overview level" is in order. This may seem backward, but when I first started in the credit game (did mortgages and ABS before credit/preferred), my CIO told me "analysts read annuals and 10ks from the back to the front". The detail before the overview. If something doesn't seem right or fit your parameters, it is often time to move along.

An overview of the funds is as follows:

Click to enlarge They all employ similar leverage, but note the expense ratios - the older funds have higher expense ratios, something to keep in mind. Dividend yields are "net numbers", so they come after the expense ratios and that may partially explain why the yield on PFO and PFD are lower than FFC and DFP.

Graphically, the dividend yields are as follows (note that these are forward looking yields based off the most recent dividend amount, or "indicated yields"):

From a yield perspective, FFC and DFP are the leaders. Recall that FFC, PFO and PFD have similar portfolios with significant overlap (there is, of course, significant overlap with DFP as well, but DFP is not as focused on preferred stock).

Next a look at trading data is in order.

Click to enlarge

Recall that FFC had the yield advantage to PFO and PFD and was close to DFP in terms of yield. FFC also has a clear advantage with average shares trading and bid/ask spread - both measures of liquidity. FFC and DFP also have lower volatility than PFO and PFD recently, but DFP is differentiated by lower volatility across 30, 90 and 180 days.

Then there is the premium. FFC, PFO and PFD all trade at sizeable premiums to NAV - the effect of the increased focus on preferred stocks by investors. DFP trades at a slight discount - differentiating it from its peers.

Historically, the F&C funds vacillate between a premium and a discount, but are more heavily weighted in trading at a premium. This, of course, makes an investment in the funds somewhat unpalatable at times. Their current premium - while recently increased - is on par (pardon the pun) with their historical premium. DFP has never traded at a premium, but is likely to soon.

And more recently, we have witnessed the funds shoot to a premium.

Finally, arrival at the "roll it all up and see what you get" total returns:

Click to enlarge

Despite its weak showing over the last six months, FFC leads the way in terms of total returns and has dominated the iShares Preferred Stock Index (NYSEARCA:PFF) across all time periods.

Annual returns:

and period returns:

Bottom Line: I like F&C as managers and have known them for some time. Their funds perform well and they have stuck to their knitting. Of all their funds, I lean towards FFC (and have a position) due to its consistent performance, liquidity and risk profile. Putting money into the CEF at current premiums is difficult and I would recommend legging into the position if you are considering starting one. I don't expect the premium to recede in the near-term given the interest in preferred stocks (just look at the number of folks starting to write about them on SA). I would prefer to own FFC (or the others) compared to PFF, as F&C have shown that their management ability adds value compared to the index.

Disclosure: I am/we are long FFC.

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.