A Deeper Dive Into The Flaherty & Crumrine Funds

Summary

• These preferreds are largely the same in terms of portfolio composition with very similar top 10 holdings and sector breakdown.
• Flaherty & Crumrine offer best-in-breed preferred stock exposure.
• They occupy the top five spots in terms of total return NAV for 1-, 3-, and 5-year performance.
• FFC, FLC is slightly cheap with PFO, DFP and PFD slightly expensive.
• Looking for a helping hand in the market? Members of Yield Hunting: Alt Inc Opps get exclusive ideas and guidance to navigate any climate. Get started today »

(This report was published to members of Yield Hunting on May 21. All data is from that date unless otherwise stated.)

The preferred space is looking more compelling in the last week having gone from a sector z-score above 1 to a z-score nearing -1. In this report, we want to analyze the Flaherty and Crumrine Preferred Stock Funds.

Flaherty & Crumrine ("F&C") is a niche sub-advisor that specializes in the preferred stock and related securities sector. They have been focusing on preferred security portfolios for institutional clients and funds since their inception in 1983.

They manage five closed-end funds and one open-end mutual fund. We list the six public investment vehicles below.

• Destra Flaherty & Crumrine Preferred and Income (MUTF:DPIAX)
• F&C Dynamic Preferred & Income (DFP)
• F&C Preferred Income (NYSE:PFD)
• F&C Preferred Income Opp (NYSE:PFO)
• F&C Preferred Securities (NYSE:FFC)
• F&C Total Return (FLC)

Let's look at an overview of the funds.

The funds are largely correlated and have a lot of the same top 10 holdings. This is why it doesn't make sense to hold multiple funds for diversification purposes. The chart below shows the total return NAV since the inception of the last fund. The dispersion between the best and the worst fund is 8% cumulative over the 6.5 year time frame.

Data by YCharts

Let's look at performance across the funds. Three-year NAV returns are very close, as one would expect given the highly redundant portfolios. But the price returns can be quite variable.

The open-end mutual fund lags in performance over most time periods as expected without any leverage. These funds have been able to borrow at 1.67% currently and invest in both retail and institutional preferreds yielding between 5% and 7%-plus earning that spread. Even during the "high" rates of late 2018, the funds' leverage costs only reached 3.25%-3.50%. While all rates have come down in the last two years, short rates and borrowing costs have come down further. There's a lag between lower long-term rates and when the preferreds get called and replaced.

Fundamentals of the funds are largely similar but there's some dispersion in the amount of coverage to the distribution as well as UNII. One of the reasons I haven't focused too much on these funds has been the lack of reporting transparency. Most preferred CEFs are from Nuveen, Cohen & Steers, and JHancock. Only Cohen and Steers and F&C report their fundamentals on a less than monthly basis.

UNII levels are hovering just above zero for three funds (DFP, PFD, and PFO) while FFC and FLC have small cushions remaining of 3.2 and 2.6 cents, respectively. While UNII levels broadly have been declining thanks to reduced net investment income ("NII") production as issues get called and replaced with lower yielding securities, FFC was able to buck the trend and increase in the last semi-annual period.

Portfolios

All five portfolios plus the open-end mutual fund are very similarly positioned. As we noted above, the top holdings are essentially the same across all five portfolios. The sector concentration, which we note below with the five images, also are roughly the same. Geographically, the funds are about 70%-75% US, 7% UK, 6% France, 4% Bermuda with a smattering of other mostly European countries. Lastly, credit quality also is very similar with about 50% of the portfolio in Baa ("BBB") and 35% in Ba ("BB") rated preferred stock. This spreads the span between investment grade and non-investment grade.

In addition, all five funds pay about the same amount in qualified dividend income ("QDI") vs. non-qualified. If you recall, QDI is a favorable tax rate on certain dividends paid by certain types of companies. If qualified the dividends are taxed at the long-term capital gain rate dependent on the shareholders taxable income. This is an important factor and can significant increase your after-tax returns.

For example, FLC had 86.6% of its income qualify for the lower rate. DFP was even higher at 91%. FFC a little lower at 83%.

FFC:

DFP:

FLC:

PFD:

PFO:

These funds are primarily holding bank and insurance companies as they are the largest issuers of preferred stocks. The top 25 issues as of the end of April read like the holdings of a bank and financier services sector ETF. While banks are at risk from this current crisis, we think they are largely utilities with significant amounts of capital behind them. Risks are fairly low, which is obviously a big benefit to the preferred shareholders.

(Source: Flaherty & Crumrime)

Valuation

These are largely homogeneous funds with slightly different positioning likely due to timing and fund sizes. We have a fairly simplistic model that looks at the five funds and assess fair value relative to each other. It incorporates the NII yield plus the small variances in costs (expense ratios and leverage expense). In other words, if the NII yields (coverage ratio times distribution yield) were all the same, the funds should have slight differences in discounts simply because some are most costly than others to generate the NII yield.

You can see the amount of leverage applied is about the same but expense ratios vary by about 30 bps from the cheapest to most expensive funds. In some cases, especially on the equity side, discounts are a byproduct of the capitalized costs in the fund, the primary one being the management fee and total expense ratio.

But liquidity is an issue as well. The less the liquidity, the greater the compensation to the shareholder in the form of a wider discount should be considered. The least liquid fund is PFD with average daily shares traded of just 35K or about 497K. The most liquid is FFC with 171K shares traded each day and 3.29M worth of shares changed hands daily.

So what we do is to use a regression analysis with discount as the independent variable and a few of these factors as dependent variables. That way the model assesses fair value relative to where the other funds are currently trading. Be cognizant of people that find some sort of intrinsic value for a fund based on cash flows as that fails to ignore the valuations of the space - what are the other funds' doing?

This is the same methodology we use on the municipal CEF side as well.

In the above chart, the peer group comp calculation attempts to do this as well but leaves out the other variables we use. This data point looks at the current discount/premium of the fund vs. the category average discount. If the figure is negative, it means that the fund is trading below the peer group average level.

Concluding Thoughts

There's an opportunity to make relative trades between these funds is there for those that want to watch all day long. For the long-term, less hands-on investor, these funds are best in breed. All five of their funds top the list for best 1-year, 3-year, and 5-year total return NAVs. Yes, you read that correctly.

(Source: CEFdata.com)

All else equal, given NAV yields, leverage costs, expense ratios, and a few other factors, FFC should trade at the highest valuation. The NAV yield is 8.0%, the leverage costs lower, and expense ratio the lowest of the five funds. It's also far more liquid than the other funds. It's trading above its long-term average premium at 8.0% vs. a 2.23% average.

The second best of the group is DFP with the worst of the five being PFO.

When to buy? Well, we will be adding to our peripheral sheets in a preferred bucket for June but all five are a bit expensive here so we would wait. The only fund that's close to FLC at a small premium compared to a small average discount.

The valuation is not going to be a hard and fast rule using a "buy under" factor. They will be run in relation to each other when they are trading at attractive valuations.

The first bogey that I'm looking for is for the funds to trade at or below their long-term average discounts. The second would be to find deviations in their relative price movements.

The chart below shows those deviations at times over the last five years. The most recent was PFD which late last year was at an anomalous premium compared to the other funds. At various times one fund or another is either too cheap or too expensive.

We will continue to watch these for an opportunity to get into one of these funds, preferably FFC.

Right now FLC and FFC are modestly cheap relative to the other funds, with PFD, DFP and PFO being moderately expensive. If you own DFP, PFD or PFO, we would recommend swapping to FFC or FLC.

Analyst’s Disclosure: I am/we are long FLC. 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.

Comments

[Pablo]

I used to hold PFO (and PFD) many many moons ago. Now just FLC (I mainly buy individual preferreds (20+% of my entire portfolio)), - FLC wanted to keep winning, so I let it run. I bought like a mad man during the man made crash. One of the few preferred funds I will keep.

[sts66]

If they have similar portfolios what's the point of having 5 different funds?

[hingroyield]

I own 3 of the funds ,FFC ,FLC & DFP , as I have found that they trade in enough of a disconnect that some are much more opportune to add to than others at different times . FFC has been the hardest to locate a good price for , the last several months until recently was fairly easy to get DFP at a good longterm hold price , seems like FLC comes available with most frequency. I hold these for income production once acquired , so its just a matter of waiting till discounts ,favorable market price occur, the window of opportunity can open & close sometimes in a matter of days ,its quite interesting to see develop & unfold as these reasonably similar funds diverge

[ijeff]

@hingroyield I think you are doing a good job of taking advantage of the temporary mis-pricing of the various similar funds. But as sts66 commented, I still don't get why F&C chooses to have 5 different funds. It might have something to do with limiting fund size. Other than that, can't think of anything.

[hingroyield]

That's something I obviously can't answer here about these funds or with Eaton Vance ,their equity funds ETG ,ETO , or their option funds EXD / ETV are essentially the same but different value metrics with different buying characteristics ,sure there are other examples certainly in the MLP space

[toromi]

Thanks for this article. I looked at all of these in January and decided to invest in FFC. It's been a wild ride since then, but the fund is almost back to where it was five months ago. I wish the leverage and expenses were a bit lower, but otherwise I'm happy with this investment. Your analysis confirmed that I made the right choice, and that there's no need to invest in any of the other funds from Flaherty & Crumrine.

Long FFC

[RealRural]

Thanks for this look at the little-known F&C CEFS. I didn't realize how similar they all were.

After reading about them on SA, I figured I'd let an experienced manager use their expertise (and leverage) to provide a decent yield better than the standard ETF preferreds. I took a flyer on FFC, and when the pandemic came calling and preferreds sank like bricks for no basis that made sense to me, I bought some more, lowering my cost basis and goosing the yield. Only wish I had bought more.

The folks at F&C have a good track record and for those of us who don't aspire to buy baby bonds or trade in and out of them, and dig deep into the weeds evaluating them, I recommend FFC. I also bought PFFA, after following the Virtus management for a while, and it has rebounded like a kid bouncing off a trampoline, now up 100% from its lows in March. Sometimes it makes sense to have someone else do the heavy lifting and manage the crisis. Paying 2.5% expense for that expertise is a no-brainer for me.

[Duken4evr11]

I have played FFC and PFF off each other for years. They generally move in the same way, but FFC is more volatile and pays higher dividends due to it's leverage and superior allocation vs. passive index PFF. PFF is much larger than FFC of course, with excellent liquidity.

When FFC gets in it's upper ranges (over $22 before the CV-19 dump), I like to take profits and buy PFF. During the pandemic dump, I sold PFF and bought FFC for under $10. Did the same in December of 2018, buying FFC for $16.50 at the time. It is great that both funds pay monthly dividends.

Right now I have been fading FFC a bit as it went over $20.50 and that price is not extreme at all, but starting to get a little high in the current climate, where at just over $35, PFF has a buck and a half or so more to run.

I always tend to own both, allocating up to 100% one way or another during extreme events. This has worked out well for me and of course paid dividends the whole time.

[MegaDivGuy]

Fortunately, I managed to pick up quite a bit of FFC moments after the dividend was increased, but before the sellers became aware of the change. My purchase price was in the $18.16 range, which popped a few minutes later . . .

[rickevantodd]

Thank you for your article. Other than FFC, why have 4 funds with relatively small asset bases ? Wouldn’t one larger fund be just as easy to manage and more economical for everyone ?

[MidwestinNW]

Thanks for the article ! I've held PFD for 14 years and FFC more recently. Increased positions in each occasionally when the time is favorable (like two months ago). As expected, they behave a little more independently with regard to the market as a whole. The relatively high dividend makes up for the lag on share price valuation. Obviously interest rates are an impact as you detailed. I like that the managers don't do any trickery with ROC as some funds (eating their own fund).

[sc21]

thank you for an insightful piece. As you correctly point out in terms of making a selection, relative delivery is a very important element in concluding which to select. sc

[hawkeyec]

Thanks for the review. Foolishly perhaps, I have all but one of F&Cs preferred CEFs. I have always liked preferred stocks, in spite of the fact that the conventional wisdom is that they are a hybrid security combining all the worst characteristics of bonds and common stock. IG preferreds pay better than bonds or stock. Even with the cost of leverage thrown in, the funds produce superior income to most of their individual counterparts and call risk is minimized. Forty percent of my best individual issues got called last year and that is getting old. I also have PFF, the general benchmark ETF for preferred stocks.

[Alpha Gen Capital]

All Pfd CEFs are expensive here.

[hueyuh1]

Naturally, I've got the one not covered... PGX, since 2014.
Curious why that one was left out, because it's an ETF?

[Alpha Gen Capital]

Yes. Its just the Flaherty and Crumrine funds too.

[TimNeuman]

Preferred CEFs comprise 11% of my income-focused portfolio. Long FLC, FPF, JPI, JPC and a few others. I enjoy the author's articles on CEFs and have learned quite a bit as I built my portfolio.

One thing I would suggest is to alert readers that all these funds are not 'pure' preferred funds. Most have substantial bond holdings as well, often as much as 40 to 50% of the fund's value. I am not aware of a purely 100% preferred fund; if one exists that would be interesting to know. In the past I have owned the ETF PFF as a preferred holding; but I switched to CEFs that use leverage. In the current low short term interest rate environment these seem the best value.

Final comment -- everyone seems to be joining the preferred CEF party now, and discounts have evaporated. Even FPF which historically has always traded at a 5% discount or more is now trading with a modest premium. I thankfully have a full allocation to my funds; if someone is looking to start a position this doesn't appear to be the best time.

[CincinnatiRick]

@TimNeuman "Final comment -- everyone seems to be joining the preferred CEF party now, and discounts have evaporated."

I think that "evaporation" in the discount to be simply a reflection in the time lag between the recovery in NAV and the visibility of that recovery to retail investors. While we have this debate re whether the economy will have a "V" shaped recovery, the recovery from the panic selloff in the preferred securities held by these CEFs has been rapid, a "V" if you will, especially so for a market sector that normally moves at a snail's pace.

I do not normally trade in preferred securities and bonds but in March, largely seeking the greater security in moving up the capital stack while still seeking out bargains, I bought a number of individual issues as well as a big hunk of FFC at 14. Now the question is whether this recovery has gone about as far as it is likely to go and whether therefor it is time to go back to my accustomed trading.

[papaone]

Great report and timely for me. I have 70% of my portfolio in cash and will soon go back into the market. I have also read all of RIDA's stuff, he is also an expert on preferreds.
I came to the conclusion that FFC was slightly better.
One question, why does C and F have these funds that look so similar?
They could combine them and save some operating costs.

[marcschare]

Why did FFC increase their distributions if it's not even covering the distribution now?

[Alpha Gen Capital]

It may be now. We don't know since the data is stale. The increase was likely due to much lower leverage costs.

[hingroyield]

FFC, FLC ,DFP & all the other Flaherty & Crumrine Preferred funds just increased their distributions due to the leverage interest rates being decreased , read the press release ,is fascinating
& " 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." Would appreciate an explanation of this why / how they were able to avoid deleveraging when prices plummeted in March like so many other funds did
flahertyfunds.com/...

[XXthCentMan]

Thanks for the article itself AGC & also to hingroyield for the observation about the F & C press release. Its caused me to guess that the private agreements that allow flexibility in financing gave the F & C cefs a real edge. That use of private agreement financing might justify a prem that others don't warrant.

[Retired Investor]

@PaulY2 To properly calculate duration, assets need a maturity date which most PFD assets don’t have. That probably explains why the funds don’t try.

[ChristopherSmith]

Great article. Thank you.

[Alpha Gen Capital]

Thanks!

[PaulY2]

I never can find even a rough estimate of the effective Duration of these funds. I like to track that for my portfolio, so I have to guess 12.0. Even the hyper complex credit swapped derivative loaded PIMCO funds have a estimated duration.

[Alpha Gen Capital]

FPF and LDP use hedges to reduce duration which they report on their fact sheets. The rest are very long duration.