Hybrid Income Strategy: 7% Yield

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About: Cohen&Steers REIT&Preferred Income Fund (RNP), Includes: EDV, VIG
by: A1 Investments
Summary

The monthly distribution is moderately established but needs better coverage.

Underlying holdings are performing well and are carrying the fund.

The fund's market price seems fairly valued considering the total return and potential issues down the road.

Price performance is rather volatile and must be considered before investing in.

Cohen and Steers REIT and Preferred Income Fund (RNP)

Main thesis

The fund offers a high current income, attractive capital growth, and is trading at a discount to NAV. The problem with this fund (and CEF’s in general) is the relatively low distribution coverage and what that means for investors. When a fund consistently pays out more in distributions than it earns, eventually they have to raise cash via debt or equity and rights offerings can be complicated. Furthermore, leverage, as investors know, magnifies investment gains and losses. In the case of RNP, price performance is noticeably more volatile than standard income investments. Income investors like retirees usually want price stability so prospective investors should hedge their bets with negatively correlated assets such as stocks.

High Monthly Income

(Source: Original Image - Data from Yahoo Finance)

As you can see from the chart above, the fund has steadily increased its distribution over the past few years and offers an amazing current yield of 7%. While we will also discuss price performance, such a high yield can be great for income investors in today’s low interest rate environment. Furthermore, there have been various Return of Capital distributions that allow for the deferral of income tax until cost basis is recovered.

Asset allocation strategy

(Source: RNP Factsheet)

The fund utilizes a creative hybrid strategy to achieve both growth and income. With a nicely diversified portfolio of equity REITS and preferred stocks, one can see how they’ve been able to deliver results to investors. However, with a 24% effective leverage ratio, interest rate sensitivity, and credit risk, RNP has a unique investment profile of risk/reward.

Income investments tend to move in a cyclical pattern and RNP is no different. With negative correlation to equities, the fund can be a powerful diversifier while also delivering high current income. The caveat of this is that RNP is significantly more volatile than traditional bond funds, performs great during bull markets, and lags peers in bear markets.

While a bear market seems unlikely for the time being, interest rate sensitivity is a concern with the Fed continuing to raise interest rates. In addition to causing downward price pressure on the market price of the fund, borrowing costs will be more expensive and decrease profitability. This is because RNP borrows and short-term rates and makes money on the spread via capital growth and dividends.

Correlation

Bull Market

Bear Market

(Source: Yahoo Finance)

Sustainability Analysis

They key to maintaining the distribution over the long-term is coverage from Net Investment Income and growth of underlying holdings. This will allow the portfolio managers to use all the fund’s resources earmarked for portfolio growth without having to supplement the NII shortfall. In the case of RNP, however, NII has covered about 60-70% of the distribution has a slight negative Undistributed NII balance. While there have been net additions to NAV after paying expenses, this is because the fund holdings have been performing well enough to do so. That cannot be relied on to maintain the distribution over the long-term. Compounding this issue is that the fund may eventually have to raise cash. If they choose to do so through debt, then borrowing costs will increase. If they issue new equity shares, there is a chance of dilution if not enough cash is raised per the NAV formula {NAV = (Assets-liabilities)/Shares outstanding}. Furthermore, rights offerings can be complicated which may not suit investors that want a hands-off strategy aside from periodic rebalancing. Stanford Chemist wrote a great article on how to play the rights offering of an equity closed end fund and can be used as an outline for CEF’s in general.

Valuation

(Source: CEF Connect)

As you can see from the chart above, RNP has traded at a discount to NAV for a few years now. The spreads, however, are thinning and the market price is getting closer to reaching NAV. While the fund does offer a great total return, the tradeoffs and potential issues highlighted above indicate that the fund is fairly valued.

The Bottom Line

Despite the strong investment profile, prospective growth and income investors should diversify their risk exposures to stabilize portfolio performance along with periodic rebalancing. Because the fund has negative correlation to equities but more volatility than traditional bond funds, funds like the Vanguard Dividend Growth index ETF (VIG) and Vanguard Extended Duration Treasury index ETF (EDV) can provide capital growth and downside protection, respectively.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.