Why We Are Seeing Distribution Divergence In Preferreds CEFs
Summary
- The highly unusual market environment, marked by extreme volatility and a sharp drop in short-term rates, has rewritten the distribution coverage rule book for CEF investors.
- We discuss why one fund family cut distributions while another raised them in the context of the preferred CEF sector.
- Among perpetual preferreds CEFs we continue to like FLC for its highest current yield and widest discount.
- However, as the overall sector premium is quite rich we would also tilt to term CEFs: JPI and JPT or the open-end fund FPE.
- This idea was discussed in more depth with members of my private investing community, Systematic Income. Get started today »
April was a bad month for CEF distributions with over 90 funds declaring cuts. Within this seemingly one-way move, the preferreds sector stood out for its surprisingly divergent behavior with one set of funds cutting distributions and another set increasing. In this article we explore the reasons for this behavior and any lessons to be learned for income investors.
Within the preferreds CEF sector we continue to like the Flaherty & Crumrine Total Return Fund (FLC) for its highest current yield, widest discount and above 100% coverage by our estimates. However, as the overall CEF sector appears quite rich in discount terms, we would also tilt to either the two Nuveen term funds: Preferred & Income Term Fund (JPI) and the Preferred & Income Term 2022 Fund (JPT) or the active First Trust Preferred Securities and Income ETF (FPE).
The Ups and Downs Of Preferreds CEFs
The chart below shows April distribution announcements for preferreds CEFs. Five funds managed by Flaherty & Crumrine increased distributions while three of four Nuveen funds decreased them.
Source: Systematic Income Service
There can be many reasons for changes in distributions - some benign and some less so. Benign reasons are those due to price or NAV-linked managed distribution policies or target term funds preserving NAV into their termination dates. Distribution cuts for these reasons are not indicative of the underlying fund earning power and can be forecasted by investors without a lot of difficulty. This is also why these types of distribution cuts are usually not met with price drops which can otherwise deliver a double whammy to income investors of both income and capital losses. Less benign reasons are those that are indicative of a loss of fund portfolio earning power and it is these cuts that income investors tend to, rightfully, worry about.
What can investors do to be aware of potential changes in fund earnings? In a normal market environment investors have two tools at their disposal.
The first is by following fund distribution coverage and earnings. Here, a fund company like Nuveen is quite helpful as they publish monthly updates of their CEF coverage, earnings and UNII figures which we also follow and make available on our service. However, a glance at the following earnings chart shows that this would not have worked in this particular case as the earnings of the funds that cut distributions have remained fairly stable over the last year.
Source: Systematic Income Service, Nuveen
Could it be because fund coverage was already subpar and the recent cuts were just a response to this? No again. Distribution coverage through March looked pretty strong, falling only very slightly below 100% for two of the funds. Keep in mind that the recent spike in coverage is due to the fact that earnings (the numerator) are calculated on a rolling basis while distributions (the denominator) are taken as of the most recent month. This spike will flatten out again over the following two months as the older higher earning months roll off.
Source: Systematic Income Service, Nuveen
So, unfortunately, in the case of cuts by the three Nuveen funds, following fund coverage and earnings data did not provide early indications of potential cuts.
Apart from fund-level information, the second factor that investors can follow to anticipate CEF earnings and distribution changes is to follow broad-based market drivers of earnings. For example, the recent drop in short-term rates will lead to lower earnings on floating-rate assets such as loans and non-agency MBS. In the case of the preferred stock market the two key drivers of reduced distributions through time have been call activity which replaces higher-coupon bearing stocks with lower coupons and negative yields-to-call which reduces fund capital. Because preferred stocks are by-and-large fixed-rate payers, their dividends are less affected by drops in short-term rates. And because preferreds prices have been relatively depressed over the month of March and April, call activity has virtually ceased as the refinancing of preferreds would require issuers to pay a higher coupon on the stocks than previously.
So, in summary, this discussion shows that neither following fund-level nor market-level information would have sent investors a clear signal of upcoming changes in preferred CEF earnings and possibly distributions. This doesn't mean that following these signals is useless. In a normal market environment they can be quite accurate. The last few weeks, however, have been anything but normal which means that investors need to dig a little deeper to understand what is going on.
Real Drivers Of Distributions, Please Stand Up?
In such an unusual market environment of high volatility and sharp moves lower in short-term rates, we need to expand our set of distribution drivers. In our view this additional set of drivers should include the following:
- Presence of floating-rate leverage instruments
- Appropriate (robust / non-regulatory) leverage instruments
- No leverage cap mandates
- No leverage cost hedges
Let's briefly discuss these in turn. Floating-rate leverage instruments like repos and credit facilities, in contrast to preferreds and bonds, allow funds to boost earnings when short-term rates fall.
What we mean by appropriate leverage instruments are those instruments that are less impacted by market volatility and depressed asset prices. This would exclude instruments like tender option bonds which allow lenders to put the assets back to the borrower in quick order. For example, in the chart below we show the extent to which the PIMCO municipal CEFs have deleveraged over the month of March with all the deleveraging coming from tender option bonds.
Source: Systematic Income Service, PIMCO
These "appropriate" instruments also exclude 1940 Act regulatory instruments like preferreds which would prevent the fund from making distributions on common shares in case of asset coverage breaches.
A lack of self-imposed leverage cap mandates gives the fund more flexibility to run at a temporarily higher leverage than would be possible otherwise.
And finally, a lack of leverage cost hedges ensures that the funds can take full advantage of drops in short-term rates in their earnings.
Let's return to preferreds CEFs and see how those funds with distribution changes in April stack up across these additional metrics.
Source: Systematic Income Service
All 8 funds had floating-rate leverage instruments which were "appropriate" by our designation and all funds in the sector use floating-rate credit facilities as their source of leverage. This means they were all able to take advantage of drops in the short-term rate and, by virtue of being private agreements, they are out of scope of the 1940 Act asset coverage rules making them less liable for a chance of deleveraging.
The real driver in the divergence of distributions had to do with leverage cap mandates as well as leverage cost hedges. The Nuveen funds have both in place and, by our estimate, the leverage caps were hit in March which was the likely driver in their deleveraging. On 17-March and 25-March we flagged up the vulnerabilities of the non-term funds. Of course the Nuveen funds did not have to cut their distributions once they deleveraged but the cuts were a simple admission of a drop in future earnings.
What To Do Now
Where does all of this leave preferreds fund investors?
Within the Flaherty & Crumrine funds our preference remains for the Total Return Fund which is trading at the highest current yield and widest discount in the group.
By our estimates FLC over the last six-month has had distribution coverage of about 104.6% which jives well with its 5.2% rise in distributions. More importantly, however, we expect the fund to have coverage around 106% over the coming 6 months which takes into account its new higher distribution rate.
Source: Systematic Income Service, Flaherty & Crumrine
That said, we do find the entire CEF sector to be quite rich in discount terms with the sector premium bumping up against its post GFC high.
Source: Systematic Income Service
For this reason we would also tilt toward the Nuveen term funds: Preferred & Income Term Fund or the Preferred and Income Term 2022 Fund which should see more resilient discount behavior over the medium term. These funds also have fairly light leverage profiles meaning they are less likely to deleverage in the medium term.
Alternatively, we also like the active First Trust Preferred Securities and Income ETF with a respectable 5.85% trailing-twelve month yield though this excludes its 0.85% fee. Alongside other open-end funds, FPE has had a much better drawdown profile in March compared to CEFs.
Source: Systematic Income Service
Conclusion
The highly unusual market environment that we have seen over the last few weeks, marked by extreme volatility and a sharp drop in short-term rates, has rewritten the distribution coverage rule book. Keeping an eye on current coverage and broad-based market factors has not proven sufficient to anticipate changes in some CEF sectors, particularly for preferreds funds. Within the perpetual CEFs we continue to like FLC for its highest current yield and widest discount among Flaherty funds. However, as the CEF sector premium remains on the expensive side we would also tilt to either the term CEFs or to the open-end fund FPE.
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This article was written by
ADS Analytics is a team of analysts with experience in research and trading departments at several industry-leading global investment banks. They focus on generating income ideas from a range of security types including: CEFs, ETFs and mutual funds, BDCs as well as individual preferred stocks and baby bonds.
ADS Analytics runs the investing group Systematic Income which features 3 different portfolios for a range of yield targets as well interactive tools for investors, daily updates and a vibrant community.
Analyst’s Disclosure: I am/we are long FLC, JPI, JPT, FPE. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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