3 Preferred Income Closed-End Funds That Should Benefit From Financial Reform

Includes: FLC, JPS, PSF
by: George Spritzer, CFA

Starting in January 2013, the "Basel III" initiative will bring new global banking regulations. In response to Basel III, the Dodd Frank Act in the US will introduce new standards with several important changes in bank capital requirements. These changes will have a major effect on the preferred securities market, since they redefine requirements for "Tier 1" capital. Many existing bank preferred issues will no longer be considered equities and will need to be refinanced.

There will likely be many investment opportunities for active investors as banks redeem certain preferred securities and replace them with other securities that still qualify as Tier 1 bank capital.

In the US, debt-structured hybrid preferred securities or trust preferreds will be losing their Tier 1 status for US banks with more than $15 billion in assets. This market has started to shrink and some banks have already redeemed securities ahead of the new standards. But there is almost $100 billion of US dollar preferreds remaining that will be impacted. Since Basel III is a global standard, the Tier 1 status of many foreign bank preferred issues will also be affected.

The bank capital Basel III recommendations are complete, but the precise implementation is not yet totally determined. As these Tier 1 regulations get clarified, we could see hundreds of billions of dollars in redemptions of bank issued preferred securities.

The new Basel III rules place tough restrictions on preferred issues that receive Tier 1 capital treatment. They must be:

- perpetual securities

- no incentive to redeem

- must have "loss-absorbing" features (e.g. convert to common equity based on trigger events)

Many US banks have traditionally issued trust preferred issues over perpetual preferred issues because the distributions are consider interest rather than dividends and are tax deductible to the issuer. When trust preferred issues lose Tier 1 status, issuers will likely view them as expensive debt funding rather than attractive equity, since they are subordinated and their yields are higher than bank debt.

Some issuers will be taking advantage of regulatory par calls. Most bank preferred issues have a provision that enable issuers to call them at par in the event of a regulatory capital change. Issues trading at a premium cause a loss if called at par. Issues trading at discounts experience a gain. Some issuers of discount issues may also use buybacks, exchanges and tender offers instead of par calls, which offer opportunities for active investors.

Preferred issues may also attract a scarcity value. Issuers have been hesitant to issue new securities until there is more clarity, but are still redeeming older issues. We may also start to see more issuance of new hybrid securities like contingent convertibles (e.g. CoCos) which satisfy the new Tier 1 capital requirements and meet the income needs of investors.

Considering the upcoming uncertainties in the preferred market, it will be important to actively monitor a preferred portfolio. For this reason, I believe an actively managed preferred closed-end fund with an experienced pro-active investment team should be able to outperform index-based preferred ETFs that passively wait for events to happen and do not actively prune the portfolio.

Three Preferred Closed-end Funds to Consider

1) Nuveen Quality Preferred Income 2

Ticker: (NYSE:JPS)

Total Net Assets: 1.45 Billion

Total Common Assets: 1.06 Billion

Expense ratio= 0.92%

Leverage: 27.05% (Average Cost of leverage= 1.45%)

Discount= -0.79%

Average 52-week discount= -3.95%

Annual Distribution Rate (market price) = 7.48%

Current monthly distribution= $0.055

Avg. earnings per share (as of 3/31/2012) = $0.0563

Earnings/Distribution Ratio= 102.36%

UNII per share= $0.0521

Asset Allocation as of 3/30/2012

Preferreds 88.32%
Convertibles 4.18%
Funds 0.95%
Cash Alternatives 6.55%

Investment Objective: JPS seeks to provide high current income consistent with capital preservation. Capital appreciation is a secondary objective.

Credit Quality (as of 2/29/2012)

AAA 1.9%
A 21.4%
BBB 66.1%
BB 8.7%
B 1.3%
Not rated 0.6%

Investment Performance NAV Return as of 05/02/2012)

YTD +11.42%

1-Year +6.27%

3-Year +34.0% annualized

5-Year -0.42% annualized

2) Flaherty & Crumrine/Claymore Total Return

Ticker: (NYSE:FLC)

Total Net Assets: 274 Million

Total Common Assets: 183 Million

Leverage: 33.3% (Average Cost of leverage= 1.20%)

Expense Ratio= 1.31%

Premium= 2.15%

Average 52-week premium= 3.75%

Annual Distribution Rate (market price) = 7.32%

Current monthly distribution= $0.055

Avg. earnings per share (as of 3/31/2012) = $0.0563

Earnings/Distribution Ratio= 102.36%

UNII per share= $0.0521

Asset Allocation (02/29/2012)

Preferreds 88.4%
Corporate Bonds 9.1%
Short term investments 0.9%
Equity 0.5%
Cash Alternatives 1.1%

Investment Objective: FLC seeks to provide a high level of current income with capital appreciation by investing in investment grade preferred securities and other income producing securities.

Credit Quality (as of 2/29/2012)

A 7.4%
BBB 73.2%
BB 16.3%
B 2.1%
Not Rated 1.0%

Investment Performance: NAV Return as of 5/02/2012)

YTD +10.59%

1-Year +11.33%

3-Year +42.58% annualized

5-Year +5.94% annualized

3) Cohen & Steers Select Preferred & Income

Ticker: (NYSE:PSF)

Expense Ratio= 1.24%

Total Net Assets: 425 Million

Total Common Assets: 296 Million

Effective Leverage= 30.0% (Average Cost of leverage= 1.20%)

Premium over NAV= 1.21%

Average 52-week premium= 0.20%

Annual Distribution Rate= 8.25%

Current monthly distribution= $0.172

Avg. earnings per share (as of 12/31/2012) = $0.1737

Earnings/Distribution Ratio= 100.99%

UNII per share= $0.0440

Asset Allocation (02/29/2012)

Preferreds 94.8%
Corporate Bonds 4.1%
Short term investments 0.8%
Cash Alternatives 0.3%

Investment Objective: PSF seeks high current income with capital appreciation by investing in preferred issues and other income producing securities issued by US and non-US companies.

Credit Quality (as of 3/31/2012)

A 0.2%
A- 3.4%
BBB+ 9.8%
BBB 25.4%
BBB- 11.7%
BB 7.9%
BB- 3.2%
B+ 2.0%
B 0.7%
Not Rated 14.1%
Cash 0.6%

Investment Performance: NAV Return as of 5/02/2012)

YTD +11.40%

1-Year +7.07%

In the current market environment, it is hard to find good leveraged preferred closed-end funds selling at a big discount. This is partially because of the Federal Reserve's zero interest policy for short term rates. But the three funds listed above are well managed and should continue to outperform passive index preferred ETFs because of the upcoming regulatory changes.

Disclosure: I am long JPS, FLC.