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Summary Flaherty & Crumrine is a preferred stock specialist offering five leveraged and hedged closed-end funds. There has been a strong trend of investment money moving into preferred stock CEFs as the high-yield credit market has faltered. FFC now holds a premium over 8%. Flaherty & Crumrine’s Preferred Stock CEFs There are categories of closed-end funds where I consider that a single sponsor offers a range of funds that make it the best in its class. For taxable fixed-income CEFs, my vote goes to PIMCO. Other fund sponsors offer some excellent competitors, but PIMCO’s full lineup is demonstrably the best in its category. For unleveraged equity-income CEFs, it’s hard to beat Eaton Vance’s array of option income funds. It would be hard to make a case that any other fund sponsor has the across-the-board strength in this category that Eaton Vance’s funds have. I’ve written about each of these recently ( How Safe Are The Distributions For PIMCO CEFs…? and Comparing The Option-Income CEFs From Eaton Vance ) where I give some rationale for those choices. I also have a comparable pick for preferred shares; it’s Flaherty & Crumrine. F&C offers five closed-end funds for the investor in preferred securities: Flaherty & Crumrine Dynamic Preferred & Income Fund Inc (NYSE: DFP ) Flaherty & Crumrine Preferred Securities Income Fund Inc (NYSE: FFC ) Flaherty & Crumrine Total Return Fund Inc (NYSE: FLC ) Flaherty & Crumrine Preferred Income Fund Inc (NYSE: PFD ) Flaherty & Crumrine Preferred Income Opportunity Fund Inc (NYSE: PFO ) We’ll have a look at them individually shortly, but first a few words on the category and asset class. Why Preferreds and Why CEFS? Preferred shares should be a core component of any income investor’s portfolio. They offer stable income with much less price volatility than common stock. They are, of course, interest-rate sensitive as are all income investments, but I am more concerned about volatility in common stocks than I am about volatility from interest-rate moves at this time. I fully expect the Fed will be true to its stated goal of gradual interest rate increases, and I further expect that experienced management can prosper under those circumstances. On the other hand, I am anticipating a difficult year for common stock, and those who have followed my thinking are aware that I am not usually found at the bears’ end of the spectrum. With that in mind, I continue to seek out more defensive positions in my portfolios. Thus, I consider a portfolio shift that reduces exposure to dividend-paying common shares and increases exposure to preferred stocks to be a prudent move. Note that I say “reduces,” a very different thing from “eliminates.” I will still carry a strong position in common shares, but I will also be increasing my allocation to preferreds. One can hold preferred shares in individual equities or ETFs, but it is my preference to look for exposure to this asset class in closed-end funds. It is one of the three areas where I feel CEFs offer the greatest opportunities for income-investors. Let’s explore why. Presently, the median distribution yield for the 17 CEFs that aggregator sites list for the category is 8.32%. Compare that with the two largest preferred stock ETFs, the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) and the PowerShares Preferred ETF (NYSEARCA: PGX ); these both have a distribution yield of 5.92%. Furthermore, I suspect investors holding a portfolio of individual preferreds will be averaging something fairly close to that yield percentage as well. So if 6% is the prevailing bar for preferred stock yields, where do the CEFs find those extra two and a third points? First, they use leverage. Median leverage for the 17 CEFs is 33.58%. Notice that if we apply that 1.33x leverage factor to the ETFs’ 5.92% yields, it works out to 7.91%. While this is still under the CEFs’ median yield to their investors, it is nearly identical to the CEFs’ median yield on NAV which is 7.86%. So, it seems that the CEFs along with the ETFs and individual share holdings are all generating close to the same level of yield. The CEFs get an added kick that pushes them to even higher yields from their discounts. The median discount stands at -7.11%. This generates an additional 41bps to the market yield over the NAV yield and illustrates the importance of buying CEFs at a discount. It is the combination of leverage and discount that drives the enhanced yields for CEFs over the EFTs. Of course, leverage adds risk, primarily as a multiplier of volatility. Leverage also adds to interest-rate risk as rising rates will make leverage more costly. Why Flaherty & Crumrine? Flaherty & Crumrine has been focused on the preferred shares market for over 30 years. The firm formed in 1983 as a manager of portfolios of preferred securities for institutional investors. It introduced its first leveraged and hedged preferred securities funds in 1991. Through its experience in the preferred securities markets, Flaherty & Crumrine has developed expertise to implement portfolio- and interest-rate management strategies to obtain consistently high levels of sustainable income. This expertise is key to functioning effectively in what the firm describes as a ” wonderfully inefficient market .” When appropriate, the F&C funds employ hedging strategies designed to moderate interest-rate risk. These are designed to increase in value when long-term interest rates rise significantly, from either a rise in yields of Treasury securities or interest-rate swap yields. In general these are used when interest rates are expected to rise. From the current literature I reviewed, it is unclear the extent to which these hedging strategies are currently employed. The Funds Each of the five funds is leveraged near 33%, which is consistent with the category. Each is invested in at least 93% preferred stocks. All but DFP are wholly domestic; DFP is 77.2% domestic with the remainder of the portfolio holding positions from U.K., Bermuda, Western Europe and Australia. F&C’s funds tend to be more tax efficient than many other preferred shares CEFs. For the 2014 tax year qualified dividend income ranged from about 62 to 70% of total distributions. (click to enlarge) I have not reviewed the category for this metric, which is significant in a taxable account, but previous analyses showed other sponsors’ funds with levels of QDI generally under 50% reflecting, in part, greater exposures to REIT preferreds. Portfolios Portfolio compositions are quite similar among them. Each is most heavily invested in financials (ex. REITs) which comprise greater than three-quarters of their portfolios in a roughly 2:1 ratio for banks:insurance. (click to enlarge) PFD and PFO do not list energy or REITs separately; instead they are lumped into “other” sectors. A cursory perusal of the published portfolios indicates a significant fraction of “other” does include energy, but I have not attempted to sort out actual percentages. DFP has the largest energy holdings of the other three funds. Utilities comprise about a ninth of the portfolios of FFC, FLC, PFD and PFO, but only 2.76% of DFP’s holdings. Performance Total return for one year is shown in the next chart. (click to enlarge) And, for the past 3 months: (click to enlarge) As we can see here, there has been a strong flow into the preferred shares funds over the past quarter driving price up relative to NAV. As a consequence, discounts have shrunk and in the case of FFC, valuation has grown to a premium. (click to enlarge) The rising prices relative to NAV for the funds is shown in the 3, 6 and 12 month Z-scores which are positive except for PFD and PFO 12 month values. (click to enlarge) The discounts and Z-scores show that bargain hunters will find little to take advantage of at this time. This has been a trend across the preferred shares category which has median Z-Scores of 0.89, 1.31 and 0.14 for 3, 6 and 12 months, respectively. The shrinking discounts mean that distribution yields are somewhat lower than when I last looked at preferred CEFs in early autumn. Distributions range from 8.06 to 8.5%, in line with the category median of 8.32%. (click to enlarge) Conclusions FFC has been a favorite of mine in the recent past and it is a fund I have held for some time, adding to my position as recently as last September. But at this time its 8% premium makes it an unattractive purchase. Indeed, anyone holding the fund may want to consider trading out of it to capture that premium which I suspect is near a peak value. This is what I have done. FLC is, in my view, the most attractive of the remaining funds. It has a distribution yield better than the category median. Its -4.0% discount is less favorable than the category median of -7.1% but is the deepest discount of the fully domestic F&C funds. Total return on NAV for the past year is stronger than FFC, even as FFC’s growing premium has driving its return on market price appreciably higher. And the exposure to energy preferreds is the lowest of the three funds where that is explicitly listed. DFP, with the same yield and a deeper discount is less appealing to me. The relatively high level of energy-sector preferreds is potentially problematic for one thing. In addition, there has been a stronger trend to discount reduction relative to FLC. If one is attracted to international exposure in preferred stock CEFs, it might be worthwhile to look more closely at the First Trust Intermediate Duration Preferred & Income Fund (NYSE: FPF ) rather than DFP. Preferred shares look increasingly to present a timely alternative to the troubled high-yield credit market for income investors. Flaherty & Crumrine offers the preferred shares investor nearly three decades of experience and five funds with strong long-term records. The firm uses hedging strategies to moderate interest-rate risk, potentially an important approach in the coming year. Money flow has been moving out of high-yield bond funds; it seems that some of that flow has been moving into preferred share funds. This has meant discount reductions for the category and, in some case, such as for FFC, premiums to NAV. One might want to take advantage of the rising valuations and trade out of fund like FFC which is unlikely to sustain its premium valuation, while retaining a position in F&C’s hedged and leveraged preferred share funds by opening a position in FLC instead. While I do, as stated, like F&C in the preferred shares CEF arena, there are other funds that should be competitive. I shall be looking at a few of those shortly.