John Hancock is a conservative fund sponsor with a respectable reputation.
HPI, HPF and HPS all just received a distribution trim, all three funds are focused on preferred shares.
HTD has exposure to preferred shares too, but the equity portion is likely to keep this fund pumping out the same distribution for a long time.
Even after the distribution cut the three funds are trading at premiums.
This article was first published on October 9, 2019.
John Hancock Tax-Advantaged Dividend Income Fund (HTD) has been one of the top-performing funds this year and personally, one of my largest holdings. There are three other John Hancock funds that also have performed incredibly well this year; John Hancock Preferred Income Fund (HPI), John Hancock Preferred Income II Fund (HPF) and John Hancock Preferred Income III Fund (HPS). These three funds, along with HTD, are all up over 21% on a total return NAV basis. Their market prices have done exceptionally well too, with HPI returning 30.88%, HPF returning 26.80% and HPS returning 28.52% for total return on market price. HTD has done even better though, showing a total market return of 44.57% YTD for its investors!
The underlying portfolio's performance can be attributed to this year's frenzy for income and the rebound from last December's rout - John Hancock being a solid fund sponsor - that doesn't hurt either. This has led all the funds to trade at quite lofty premiums. Although, for the three focused primarily on preferred shares it would appear these lofty valuations began last year before ramping up into this year. In contrast, HTD hasn't traded at premium levels since the fund's inception in 2004.
Additionally, when looking at the funds side by side, we can see that premium territory isn't new to HPI, HPF and HPS. However, what may be a surprise is that those three funds just recently announced distribution cuts. They weren't anything major but still took a little wind out of their sails, still not enough to get any of the funds to trade at a discount though.
I think it is quite obvious to see when the funds announced their distribution cuts looking at a YTD chart. All three funds had an immediate dip upon the announcement.
HPI cut from $0.14 to $0.1235 per month, an 11.8% decrease. HPF cut from $0.14 also, to the same $0.1235 per month for the same 11.8% decrease. HPS cut from $0.1222 to $.11, a 10% cut. For comparison purposes, HTD announced the same $0.1380 rate.
But the question is was it necessary or was John Hancock just being too conservative? And why is HTD safe from a distribution cut? The short answers are; they were necessary and HTD's distribution is safe, in my opinion.
Necessary Cuts And HTD's Distribution Is Safe
The leading cause of the cuts has to do with the fund's underlying holdings. The fact is that the three funds that cut are primarily focused on holding the bulk of their assets in preferred securities. This means that they rely heavily on net investment income [NII] to continue to pay out a healthy distribution. Whereas HTD, on the other hand, had preferred securities make up 37.6% of their portfolio as of their latest Semi-Annual Report.
(Source - HTD Semi-Annual Report)
This is important because of the simple fact that they don't rely so heavily on NII to fund their distribution. This is because the common stocks in their portfolio make up 52.4% of their assets and can use a good portion of capital gains to fund their distribution. However, they do still have some great NII coverage in which I explained in a prior article on HTD.
As we can see, total distributions for the 6-month period is $43,633,196. However, this includes the very generous special distribution of $0.4051 paid out in December 2018. When taking that distribution out, the total distribution for the 6-month period would drop to $29,298,747 (Shares outstanding of 35,384,961 x $0.138 x 6 months).
This means that the net investment income covered 74% of the fund's distribution!
It still gets better for HTD and reinforces my point when we look at the fund's unrealized appreciation too. They have this to say in their Semi-Annual Report.
At 4-30-19, the aggregate cost of investments for federal income tax purposes was $1,086,139,746. Net unrealized appreciation aggregated to $249,171,279, of which $267,739,259 related to gross unrealized appreciation and $18,567,980 related to gross unrealized depreciation.
So, the underlying portfolio has unrealized gains of $249,171,279. Of course, these can disappear if we start to see losses as these are just "paper gains." Regardless, this provides quite the buffer for the fund, even in the event of a slowdown. We can also take a look at the fund's official tax characterization for the prior two years taken from their Annual Report.
(Source - HTD Annual Report)
As we can see, the fund has hardly even needed to turn their unrealized cap gains into realized cap gains to fund the distribution. This can help explain the fund's generous special year-end distributions that they have been able to pay out for the last few years.
For comparisons purposes, we will look at the same metrics of HPI, we will see exactly why they needed to cut. We will pick on HPI for the fact that it trades at the highest premium of almost 8% of the three other preferred funds. (Although, to be fair, remember HTD is trading at one of the highest premiums its ever reached too!) For HPI's information, we will be pulling it from their latest Annual Report that just became available recently. It is for the period ending on 7/31/2019.
(Source - HPI Annual Report)
As expected, the portfolio is primarily composed of preferred securities. Additionally, there is quite a bit of exposure to corporate bonds as well coming in at ~18% of the portfolio. This also doesn't help the case for being able to rely on capital gains for funding their distribution. Thus, we are left with a fund that needs strong NII or risk NAV erosion.
(Source - HPI Annual Report)
From the top line, we can see that the fund had NII of $34,842,691, and they also paid out total distributions of $43,747,192. We don't have to do any extra calculating because HPI (and the two others) didn't make any special distributions. With those two numbers in mind, we can calculate that the fund could cover about 80% of their distribution from NII for the last 12-months. Right there we know that this isn't sustainable. The underlying portfolio does show unrealized appreciation but is quite insignificant as preferred issues generally trade around par value. Also, this is representative of a full year factoring in the December selloff and the subsequent rebound into 2019.
HPI is smaller than HTD, HPI has about $851 million in total assets compared to HTD at $1.365 billion. HTD's numbers above also show the period of the December selloff and subsequent rebound too. We still see significantly more in unrealized appreciation on the portfolio, as we would expect because of the underlying common stocks in the portfolio. We can look at the total number of unrealized appreciation in HPI's portfolio too.
At 7-31-19, the aggregate cost of investments for federal income tax purposes was $823,973,550. Net unrealized appreciation aggregated to $20,297,568, of which $33,585,473 related to gross unrealized appreciation and $13,287,905 related to gross unrealized depreciation.
Clearly, we can see that HPI doesn't have nearly the same "cushion" for utilizing capital gains in their portfolio that HTD does. In fact, if the fund had to continue paying that same distribution it wouldn't be long before they had used up the underlying unrealized appreciation. We can also take a look at their distribution breakdown for the last couple of years to gain an even better understanding of what's going on.
(Source - HPI Annual Report)
We can see that they utilized return of capital [ROC] for a portion of their distribution in the prior year. Now, this wasn't necessarily destructive ROC. This is because in the last 1-year period the fund had a positive return. This is reflected with the NAV at $21.41 on July 31, 2019, and $21.26 on July 31st, 2018. The numbers were all quite similar for HPF and HPS too, right around 80% of the distribution being covered through NII. The unrealized capital gains are very close as well on all three, and the ROC is present in these two also.
We hold HTD in our Taxable Income portfolio at the CEF/ETF Income Laboratory and some members hold HPI, HPF and HPS that were concerned about distributions cuts coming to HTD too. I don't believe that is something we have to worry about for the time being. The underlying portfolios are different, where HTD can rely on capital gains in the portfolio and, additionally, is sitting on quite a large buffer of unrealized gains too at this moment. The common stock in the portfolio provides for the continuation of the distribution, but it should also be noted that during a severe and prolonged downturn this common stock can have a negative effect on HTD too. Distributions are never guaranteed and can be cut at any time, this is just merely my opinion when looking at the numbers.
All four of the John Hancock funds are trading at quite lofty premiums at present, none of them make an exceptional buying opportunity. This is even true for HTD, which we have rated as a "Hold" at the Lab. However, I would feel a little better possibly initiating a small position in HTD before the other funds at this time, if I had to choose. HPI, HPF and HPS got knocked down due to cutting their distributions but not to a level that quite makes sense yet. This is true even based on their historical premium levels, they are still trading on the higher side. Overall, the market has been clamoring over high-quality income investments like these funds from John Hancock. The elevated levels could still continue too as we continue into uncertainty and a search for yield. Ultimately, holding still makes sense.
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Disclosure: I am/we are long HTD. 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.