The 'Off The Shelf' Preferred Portfolio - Part II

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Includes: JPS
by: Rubicon Associates

Summary

Spectrum Asset Management funds (Nuveen) trade at a discount to NAV and have an attractive yield.

Nuveen is merging the three funds and changing investment guidelines.

I believe the new guidelines and benchmark changes will lead to increased volatility.

The impact of the merger on the expense ratio is positive, but the amount is uncertain.

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

Having written on Flaherty & Crumrine, the focus of this research will be Spectrum Asset Management

Originally, I was going to skip the Spectrum funds, due to the merger that is occurring between the three funds.

On March 22, 2016, shareholder approval was completed. The reorganization will become effective before the opening of business on May 9, 2016

I have a couple thoughts on this "merger" that I will address later in the research (in the opinion section).

Spectrum Asset Management is an independently managed wholly owned subsidiary of Principal Global Investors, LLC, founded in 1987 is one of the country's leading managers of preferred securities. Spectrum specializes in the management of diversified preferred security portfolios for institutional investors. Currently, Spectrum is sub-advisor to the preferred securities component of several Nuveen Closed-End Funds. Spectrum Asset Management is led by two principals with a combined 50 years of preferred securities experience. The investment team averages more than 15 years each in the preferred securities market. Spectrum uses a value-oriented management style, which emphasizes rigorous research to identify appropriate companies, sectors and market opportunities.

Meet Your Manager:

L. Phillip Jacoby

Mr. Jacoby joined Spectrum in 1995 as a Portfolio Manager and most recently held the position of Managing Director and Senior Portfolio Manager until his appointment as CIO on January 1, 2010, following the planned retirement of his predecessor. Prior to joining Spectrum, Mr. Jacoby was a Senior Investment Officer at USL Capital Corporation (a subsidiary of Ford Motor Corporation) and co-manager of the preferred stock portfolio of its US Corporate Financing Division for six years. Mr. Jacoby began his career in 1981 with The Northern Trust Company, Chicago and then moved to Los Angeles to join E.F. Hutton & Co. as a Vice President and Institutional Salesman, Generalist Fixed Income Sales through most of the 1980s. Mr. Jacoby holds a BSBA (Finance) from the Boston University School of Management.

Mark A. Lieb

Prior to founding Spectrum in 1987, Mr. Lieb was a Founder, Director and Partner of DBL Preferred Management, Inc., a wholly owned corporate cash management subsidiary of Drexel Burnham Lambert, Inc. Mr. Lieb was instrumental in the formation and development of all aspects of DBL Preferred Management, Inc., including the daily management of preferred stock portfolios for institutional clients, hedging strategies, and marketing strategies. Mr. Lieb's prior employment included the development of the preferred stock trading desk at Mosley Hallgarten & Estabrook. Mr. Lieb holds a BA in Economics from Central Connecticut State College and a MBA (Finance) from the University of Hartford.

Nuveen Quality Preferred Income Fund (JTP) invests at least 80% of its managed assets in preferred securities, and up to 20% of its net assets in debt securities, including convertible debt securities and convertible preferred securities. The fund invests at least 65% in securities that are rated investment grade (BBB/Baa or better by S&P, Moody's, or Fitch) at the time of investment. The fund uses leverage. Nuveen Quality Preferred Income Fund 2 (NYSE:JPS) invests at least 80% of its managed assets in preferred securities, and up to 20% of its net assets in debt securities, including convertible debt securities and convertible preferred securities. The fund invests at least 65% in securities that are rated investment grade (BBB/Baa or better by S&P, Moody's, or Fitch) at the time of investment. The fund uses leverage. Nuveen Quality Preferred Income Fund 3 (JHP) invests at least 80% of its managed assets in preferred securities, and up to 20% of its net assets in debt securities, including convertible debt securities and convertible preferred securities. The fund invests at least 65% in securities that are rated investment grade (BBB/Baa or better by S&P, Moody's, or Fitch) at the time of investment. The fund uses leverage.

Essentially, all the same objective and guidelines. Importantly, Nuveen offers other preferred and income funds, but the analysis here is focused on those funds managed by Spectrum.

Before looking at valuation, a comparison of the three 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 three 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 and I would expect the merged entity to initially look like the average of the three.

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:

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The last two funds are the most similar, but again, I expect it to initially look like the average.

Now that we have seen that the funds are similar, 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:

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The leverage is mainly the same, but note the expense ratios as compared to the F&C funds I last reviewed, which averaged 71bps.

In terms of yield, we see the following:

From a yield perspective, investors are almost indifferent between the funds.

Next a look at trading data is in order.

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Unlike the F&C funds, all of the Spectrum funds are trading at a discount to NAV, which most investors seem to find compelling.

Also similar to the F&C funds, the popularity of preferreds in a low rate environment has been helping close the discount to NAV:

Which is more evident in recent data:

Finally, a look at the total returns of the funds is in order.

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Looking at the annual return data, we can see that JPS experiences higher highs and lower lows than the other two funds, with JTP turning in the most consistent returns:

Again, JTP's returns have been the most consistent, but all three funds have performed well:

Ultimately, however, the returns have lagged those of F&C, which must be factored into any purchase decision.

Earlier, I stated I would opine on the merger between the funds. I am not a fan. Let me explain. Along with the merger, they are changing the policies guiding the funds, specifically:

  • The Board approved changes to the funds' non-fundamental policies related to the minimum allocation to investment grade securities. These changes are to better align the funds' strategies with evolution in the preferred securities market since the funds' launch in 2002. The minimum allocation to investment grade securities for each fund is being reduced from 80% to 65% effective immediately.

After the merger, the Board has approved the following changes:

  • Further reducing the minimum allocation to investment grade securities from 65% to 50%

Let's think about this for a second. Drop the minimum investment grade, then drop it again. I understand that many financial preferreds are no longer investment grade, but talk about goosing the yield through increased risk. To me, two things evidenced that they are going after yield:

The Board's actions are expected to offer a number of potential benefits to fund shareholders, including: The potential for higher net earnings, as a result of the acquiring fund's greater investment flexibility and increased use of leverage, may support higher common share distributions, and result in a more attractive yield, which may increase investor appeal and, in turn, enhance secondary market trading prices of common shares relative to net asset value

and

The current Blended Index consists of 55% BofA/Merrill Lynch Preferred Stock Fixed Rate Index and 45% Barclays Tier 1 Capital Securities Index. The proposed Benchmark Index will consist of 40% BofA/Merrill Lynch Contingent Capital Index (NASDAQ:COCO) and 60% BofA/ Merrill Lynch All Capital Securities Index (I0CS).

When I saw the 40% inclusion of COCOs, I was, to say the least, surprised. This is a massive allocation to this market and I am expecting the risk and volatility of the fund to increase with the new benchmark.

Bottom line: They are trading quality for income, hoping that investor demand for income drives shares to the NAV and increases near-term performance. I expect that it will be more volatile as a result, and if I want more volatile, I will increase my allocation to emerging markets and high yield. Not a fan of this move.

Next, the board says:

The acquiring fund will recognize operating cost savings and operational efficiencies because certain duplicative fees and expenses incurred by each stand-alone fund prior to the merger (e.g., board-related fees, fees for legal services, accounting, regulatory filings and printing) will be eliminated and, following the merger, such fees and expenses will be spread over a significantly larger asset base.

Assuming the fee schedule currently in place for the funds holds, the management fees should drop and help reduce the onerous expense ratio:

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I guess we will have to wait to see what the expense ratio will shake out to. I am expecting it to drop 10-20bps, which should help support shares.

Bottom, bottom line: I like Spectrum and have known them for a while, but I am not a fan of the policy changes or the benchmark change as I believe it will lead to greater volatility and increased risk. I will be on the sidelines until I see how it shakes out and where the expense ratio settles in.

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.