In our follow-up article focusing on the John Hancock Preferred Income Fund (NYSE:HPI), we would like to update our readers on what has been going on in the power and telecommunication industries after the outbreak of the COVID-19 pandemic earlier this year. This CEF has continued to recuperate from its market bottom in late March 2020; however, the market price is still down around 7% year to date. Communications services holdings have been the biggest contributor to the overall Fund's performance in FY 20, while energy holdings have been the biggest contractor. Lockdown restrictions have put into jeopardy the demand for commercial and industrial power, while the demand for data and residential power has been robust, as people work from home and spend more time at home. Surprisingly, a monthly distribution payment of $0.1237 per share has remained steady so far in 2020, even though the Fund has faced almost a 60% drop in market price during the peak of the coronavirus crisis in late March 2020. In our view, the key bullish catalyst is the defensive structure of this fund as we anticipate that utilities and communication services industries are well-positioned to capitalize on the economic recovery after the end of the COVID-19 pandemic. In addition, the low-interest-rate environment should persist over the next couple of quarters, which supports the demand for preferred securities over risk-free assets.
The COVID-19 impact on Utilities and Communication Services
Top 10 Holdings (as of 08/31/2020)
(Source: John Hancock)
The fund has maintained its selection of top 10 issuers pretty much the same after our first analysis in June here. However, the exposure to the top 10 holdings has been reduced from 57.7% to 49.1% as part of portfolio de-leveraging. In addition, the fund has maintained a very high share of non-investment grade securities, as they make up approximately 48.2% of total market value. Likewise, the investment-grade quality of this fund was reduced from 51.2% in May 2020 to 46.7% in August 2020. This comes a bit alarming to us, as we don't prefer such a high exposure to 'junk-level' securities, especially now, when a lot of businesses in the most hard-hit industries are a step away from filing bankruptcy or have already gone bankrupt.
"Research from investment bank Jefferies shows that large-firm bankruptcies shot 244% higher year-over-year in the July-August period, and that large-firm bankruptcies in 2020 through the end of August have more than doubled from the same point in 2019."
(Source: Kiplinger)
Nevertheless, we like the fact that the portfolio management team has decided to go overweight the United States Cellular Corporation (USM) and increase exposure to Telephone and Data Systems (TDS).
(Source: Annual Report FY '20)
Communication services companies have been one of the biggest contributors to the overall fund's performance in the H2 FY20, as they have been resilient and even positively impacted by the COVID-19 pandemic. In general, plenty of daily physical interactions like shopping, business meetings, socializing with friends or family have turned digital and virtual due to stay at home orders, thus driving demand for mobile and broadband data and network capabilities.
To date, COVID-19 has increased data traffic about 20% to 25%, and our network has been able to handle that extra demand."
(Source: Earnings Call Transcript - TDS)
In addition, there is an ongoing development of 5G networks throughout the U.S., which should enable customers to work from home, have a better mobile coverage wherever they go, and even turn their homes into an interactive environment with enhanced digital experience. As a result, communication services companies should be positively impacted by this higher demand for data; however, an implementation of a 5G network comes at a cost. TDS is a smaller telecommunication provider based in Chicago, which doesn't have the scale and customer network like the big three giants Verizon (VZ), T-Mobile US (TMUS), or AT&T (T). Despite that, management is optimistic it can monetize on the upcoming novelties of the 5G networks, like connected IoT devices, and even bring new mobile services to its customers.
"Our network modernization program continues, adding capacity and speed, launching 5G services commercially, and preparing for remaining VoLTE deployments. In these unprecedented times, our high-quality network has remained strong."
(Source: Earnings Call Transcript - TDS)
On the other, the energy industry has been far hit by the COVID-19 pandemic, as non-essential industries were shut down and people are advised to work from home leading to a lower commercial and industrial demand. That is also one of the reasons why energy holdings have negatively impacted the performance of the fund in the second half of FY 20. Nevertheless, we believe that the energy and power demand will return back to the pre-pandemic level as soon as the crisis is over. In times of a turbulent market environment or during an economic recession, plenty of times investors forget that the crisis should not last forever and there are more optimistic times about to come. In general, energy companies like DTE Energy (DTE), CenterPoint Energy (CNP), and Duke Energy (DUK) have been able to weather the coronavirus storm in H1 2020, primarily driven by strong cost-saving initiatives and a higher residential demand thus offsetting a decline in the commercial demand. CenterPoint Energy and Duke Energy have experienced a decline in commercial and industrial demand of approximately 15% in Q2 20, while a residential demand was up approximately 5%. Another important driver of residential demand was warmer than expected weather in summer, as people were working from home so there was a higher usage of air conditioning. Usually, they adjust or turn off their air conditioning, while they are in the office or at their workplace.
In our view, a couple of energy companies in the top 10 list like DUK and CNP might be takeover targets in the near future. Even though overall M&A activities in the corporate world have stopped during the shutdown of our economy in March 2020, the M&A market has become way more active over the last couple of months. In our view, the management of major companies has started to appreciate the scale that comes with the size of the company especially now during turbulent times.
NextEra Energy (NEE), the largest electricity provider in the U.S. has recently made a takeover approach to acquire Duke Energy. Combined companies could create the largest player in the utility industry of more than $200 billion in market cap, which could give them great bargaining power over competitors. The energy industry is undergoing a rapid shift into emission-free energy production as major players are shifting away from coal into renewable sources like solar or wind.
Weisel noted that with its renewables and storage capacity, NextEra has among the best ESG profiles in the industry, while "Duke, by contrast, still relies heavily on coal (~15 GW) and other emitting resources."
Weisel continued, "We expect NEE would accelerate emission reductions for [Duke's] subsidiaries relative even to [Duke's] ambitious plans to be net-zero by 2050, supported by the recently filed IRPs in the Carolinas.
(Source: Utility Dive)
In our view, we anticipate a larger wave of M&A activities, as larger companies will look for ways to expand their network. On the other hand, smaller companies might not have sufficient capital to make necessary investments to improve their ESG profile, thus shareholders are more likely to improve a potential takeover. For instance, even CenterPoint Energy, which is owned by an activist investor group - Elliot Management - has announced a strategic review in May 2020 but was not open for sale at that time.
That is why we believe that this CEF is well-positioned to capitalize on this M&A trend in the near future, as it might be able to sell some of its holdings at a premium. Energy companies have also shown their commitment to social responsibility initiatives, as they assisted customers who have been hit by the pandemic, by allowing them to defer payments and not cutting them off electricity plans.
For example, we significantly streamlined payment plans for those who are impacted by COVID-19 and continue to help connect our most vulnerable customers with energy assistance programs. We did this with extensive cooperation with the MPSC and the Department of Health and Human Services and are extremely thankful for their cooperation."
(Source: Earnings Call - DTE)
In addition, even communication services companies like TDS have announced plans to assist customers, who have been negatively impacted by the pandemic.
We signed the FCC's Keep Americans Connected Pledge where we committed to not disconnect customers who are experiencing COVID-19 related challenges for non-payment through June 30."
(Source: Earnings Call - TSM)
Nevertheless, we are still concerned about the near-term future of the power industry, if our government fails to sign a second stimulus check or stops with a monetary aid for most hard-hit small businesses like bars or restaurants, industries like travel, or recently unemployed active workplace. It could end up like a domino effect as millions of unemployed Americans, who are now receiving support from our government could fail to pay their most basic utilities bills. That would definitely result in a huge loss for power companies, while power companies might even be forced by our government to the forbearance of electricity bills. That is one of the risks which our readers should definitely keep in mind if they plan to invest in this CEF. Especially now, when Europe is facing a second wave of infections and local governments are running out of options and might be even forced to shut-down the economy again in the near future. Also, in the U.S., there have been some regional spots where there has been a resurgence of cases.
Even though the fund is committed to investing in preferred shares or debt securities, in the case of a major turmoil in the electricity market, investors in both asset classes would still face short-term losses. However, we like the fixed dividend payments of preferred stocks or interests of debt securities as investors still receive a payment during present unprecedented times and have better protection in the case of bankruptcy.
Performance
Both historical market price and NAV have been recently able to recover after initial turmoil earlier this year closer to the pre-pandemic level of $20 per share. In general, we maintain a positive outlook for preferred equities over the next couple of quarters, primarily driven by the Fed's decision to maintain interest rates unchanged at least until 2023. That is also one of the reasons why investors might flood the preferred equity market in the near future.
Even HPI's portfolio management team is very optimistic about the future performance of the preferred securities.
The yields on preferreds looked very attractive relative to the 10-year U.S. Treasury bond as of the end of July, at wide levels not seen since the 2008 financial crisis. As the economy slowly goes back to normal, we expect this spread to revert to the historical mean, which will likely provide significant upside to preferred securities"
(Source: Annual Report FY '20)
According to the figure above, the S&P 500 index has been very volatile since the outbreak of the COVID-19 pandemic in the U.S., while the largest ETF in the investment-grade corporate bond field - LQD - offers the lowest yield over the last decade.
On the other, the largest preferred equity ETF on the market - PFF - offers an approximately 470 bps higher dividend yield compared to the U.S. 10-Year Treasury rate. In fact, this gap was a bit narrower at approximately 350bps at the beginning of 2020.
(Source: John Hancock)
Based on historical performance (market price) year-to-date, HPI has underperformed both ICE BofA hybrid preferred securities benchmark and blended benchmark by roughly 1075 bps and 1300 bps, respectively. Even though HPI has been recently negatively impacted by the COVID-19 pandemic, it has still generated a larger annualized total return compared to its benchmarks by more than 200 bps over the last 10 years.
This definitely supports our view that this type of CEFs is more suitable for long-term investors, as they tend to perform better over a period of more than 10 years compared to the shorter term. Firstly, investors take advantage of the dividend reinvestment plan thus leading to a higher accumulated wealth over time. Secondly, we believe that over the longer business cycle of 10 years or more economic growth tends to be less volatile, thus the portfolio management team has an easier task to track the general performance of the underlying asset class.
This chart indicates that the fund has underperformed both of its peer ETFs on the market - the iShares Preferred & Income Securities and iShares Core U.S. Aggregate Bond (AGG) by a wide margin of more than 1500 bps year-to-date.
In addition, HPI has been the biggest laggard so far in 2020 compared to its closest peers among closed-ended funds including Nuveen Preferred & Income Term Fund (JPI), First Trust Intermediate Duration Preferred & Income Fund (FPF), Cohen & Steers Limited Duration Preferred, and Income Fund (LDP) and Flaherty & Crumrine Preferred Securities (FFC).
Looking at a historical discount/premium to NAV year-to-date, it has reached a bottom of approximately -10%, as the result of the shutdown of our economy in March 2020. Interestingly, the discount/premium to NAV metric has returned back to 10% in August 2020, as a result of the large demand for preferred securities, primarily driven by the very low-interest-rate environment. However, a potential threat of the second wave of coronavirus infections in the U.S. has weighed down the performance of major stock market indexes over the last month, triggering the drop of HPI's discount/premium to NAV closer to the 1%. In our view, this level is a way more reasonable than paying a premium of more than 5%, when there are still so many coronavirus related risks surrounding the future performance of our economy and local businesses.
Financial Highlights
(Source: Seeking Alpha)
HPI has returned to its shareholders a steady monthly distribution of $0.1235 over the last year. That makes up a current distribution rate (market price) of 7.87% as of 10/02/2020.
(Source: Annual Report FY '20)
According to the figure above, the fund reported a net investment income of $36.7 million in FY 20 or up $1.9 million y/y. However, change in net unrealized appreciation (depreciation) was -$55.4 million compared to a $14.2 million a year ago as a result of the forced sale of some assets and portfolio related losses because of the coronavirus crisis.
For instance, portfolio management has decided to sell preferred equities of a midstream company - Kinder Morgan (KMI), whose industry has been negatively impacted by stay-at-home orders resulting in the historically low crude oil prices. Another reason for forced "fire-sales" of assets was also to reduce leverage.
Interestingly, the fund was able to pay almost the entire distributions to shareholders from earnings of $37.5 million in FY 20, while the return of capital was only $2 million. This doesn't come as a surprise to us as the defensive portfolio construction of this fund with a high share of preferred equities primarily invested in utilities and financials has been resilient enough so far to weather the initial coronavirus related storm.
To sum it up, we anticipate that the monthly distribution rate should remain at $0.1235 over the next couple of months, as the financial performance in fiscal 2020 has been solid in our eyes. However, we cannot emphasize how we are still concerned about the second wave of coronavirus infections in the U.S. and a potential additional complete shutdown of our economy. The U.S. financial markets and the overall business environment could really reach a new uncharted territory and we really cannot predict how things might unwind if we face an additional month or even two of strict lockdown restrictions. That is also one of the biggest risks, which could lead to a monthly distribution rate cut over the next couple of quarters.
Conclusion
This fund has shown a great resiliency so far, as it has produced a 5.5% higher net investment income in FY 20' compared to a year ago despite the turbulent pandemic environment. However, we don't like the fact that the fund has reduced its share of investment-grade securities by approximately 5% and increased its share of 'junk' securities by approximately 3%. That creates a higher risk for shareholders that could lose again more than 50% of their market price value in the case we face another unexpected risk event like was the COVID-19 outbreak in the U.S. earlier this year.
Even though the fund trades now at a lower premium to NAV than in our previous article, we keep our NEUTRAL rating over the next twelve months. Likewise, we keep our estimate that the fund should be able to maintain its monthly dividend payment of $0.1235 over the next 3-6 months. However, the major risk remains that the potential bigger-than-expected second wave of coronavirus infections, which could disrupt 'non-essential' businesses. Consequently, it could have a negative impact on power demand and lead to higher defaults on basic utility bills. That would definitely have a negative impact on utility holdings of this CEF. In addition, investors should keep in mind a potential excessive share dilution or any kind of political risks, which might emerge now during an election period in the U.S.
