- 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.
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(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.
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.
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%.
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)
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.
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.
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.
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This article was written by
Alpha Gen Capital is a former financial advisor and his analysis is meant to provide a relatively safer income stream with CEFs and mutual funds. He has been writing about investing on Seeking Alpha for the past decade and he aims to help investors better understand how to properly construct a portfolio.Alpha Gen Capital leads the investing group Yield Hunting: Alt Inc Opps, where along with his team of analysts, he focuses on closed-end funds and getting yield from bonds to complement dividend portfolios. The service is dedicated to income investors who are searching for yield without the high risk of the equity market. Additionally, they provide 4 actively managed portfolios. Learn more.
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.
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