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Preferred Shares From Flaherty & Crumrine: 1 To Buy And 1 To Sell

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.

Asset Class Weekly: Preferred Stock Collateral Damage

Summary The preferred stock market has come to be seen by many investors as a refuge in post financial crisis markets. But for those allocated to the preferred stock space, now is not the time for complacency. Preferred stocks have not been without their own past periods of extreme downside volatility. And the asset class resides worryingly close to the current wildfires now blazing in the high-yield bond market. The preferred stock market has come to be seen by many investors as a refuge in post financial crisis markets. Price performance has been notably consistent and income has been relatively generous at a time when those living on fixed incomes are starving for yield. And unlike other high-yielding markets such as high-yield bonds (NYSEARCA: HYG ) and master limited partnerships (NYSEARCA: MLPI ), it has not fallen victim in recent years to sudden bouts of unsettling downside volatility. But, for those allocated to the preferred stock space, now is not the time for complacency. Preferred stocks have not been without their own past periods of extreme downside volatility. And the asset class resides worryingly close to the current wildfires now blazing in the high-yield bond market. Preferred Stocks: A Lot To Like Up until recently, I had been meaningfully allocated to preferred stocks for some time. The reasoning for this maximum strategy allocation to the asset class was driven by the fact that there is a lot to like about the preferred stock space. First, preferred stocks were a more fairly valued option in an otherwise richly-valued high-income universe. Preferred stock yield spreads relative to U.S. Treasuries have been fairly consistent throughout the post-crisis period. According to the iShares S&P Preferred Stock Index (NYSEARCA: PFF ) relative to a benchmark 10-year Treasury yield, the current spread is at 3.7%, which is in the middle of the post-crisis range and well above the levels seen prior to the financial crisis in 2007 when this spread had dipped below 2%. (click to enlarge) And on an absolute basis, yields have remained relatively attractive at above 6% after cresting as high as 7% in late 2014. And this absolute yield is consistent with what we have seen from the category over the past decade. (click to enlarge) Adding further to the appeal of the preferred stock asset class has been the relative quality advantage enjoyed by preferred stocks relative to other higher-yielding alternatives. For although owning preferred stocks in their various structures rank lower on the capital structure than the offerings in the high-yield bond space, investors are standing on the rungs of higher-quality companies that boast credit ratings that are “A” or better in many cases. Moreover, a vast majority of the preferred stock universe at more than 80% is made up of companies in the financial sector. While this dedicated sector exposure proved highly problematic during the financial crisis (more on this point later), in the current environment, it actually represents an advantage. For example, more than half of the preferred stock universe is made up of issuance from the systemically important financial institutions such as Bank of America (NYSE: BAC ), Wells Fargo (NYSE: WFC ), U.S. Bancorp (NYSE: USB ), JPMorgan Chase (NYSE: JPM ) and Goldman Sachs (NYSE: GS ) among others. And the one thing that has been relentlessly demonstrated by monetary policymakers during the post-crisis period is that the health of these institutions will be guarded and protected by policymakers at all costs no matter what new operational missteps are made in the future. So, for all of these reasons, the preferred stock space has been an ideal destination for capital during the post crisis period. And the consistently strong price performance from the asset class has been rewarding in recent years. (click to enlarge) But market conditions have been changing in 2015. And the risks are now rising for what has been a placid destination in recent years. A History Not Without Trauma While the last few years have been a blissful period for preferred stock investors, this has not always been the case. The asset class has endured its own periods of extreme trauma throughout history. (click to enlarge) For example, during the financial crisis, while the stock market as measured by the S&P 500 Index (NYSEARCA: SPY ) fell by more than -50% from peak to trough, the preferred stock universe performed measurably worse in falling by nearly -65% over the duration of the crisis. Of course, much of this downside was driven by the heavy weighting to financials in the asset class. And while this characteristic may imply a degree of downside protection today, if we do find ourselves in the midst of another global financial accident, the category would likely suffer disproportionately once again under such a scenario. The Threat Of Collateral Damage Today The larger risk facing the preferred stock universe today is the threat of collateral damage spilling over from the high-yield bond space. Why exactly would challenges in the lower credit quality segment of the high-yield bond space impact investment-grade-rated preferred stocks largely concentrated in financials? Because many of the money managers that operate in the high-yield bond space are also the same investors actively involved in owning other high-yielding investments such as senior bank loans (NYSEARCA: BKLN ), convertible bonds (NYSEARCA: CWB ) and preferred stocks. Why would this matter? Because, if you are a money manager that is in a cash crunch and the high-yield bonds that you own have turned illiquid, you will likely turn to sell the other higher-quality assets that are still liquid in order to raise cash. This is where the contagion effects of illiquidity in a certain segment of financial markets starts to spread. For just like the high-yield bond space, the preferred stock universe is not the most liquid category in financial markets despite the fact that these securities trade on an exchange. While some of the larger preferred stocks trade with reasonable volume under normal market conditions, it is nothing like what is seen in the common stock market, as bid-ask spreads are often wide on any given trading day. And a fair number of preferred stocks trade with volumes in the thousands to hundreds on any given day with some periodically going untraded on any given day. As a result, if liquidation pressures were to spill over into the preferred stock market in earnest, we could quickly see staggeringly dramatic intraday price movements that can extend for days, weeks or even months depending on the degree of market stress. For the nimble investor, such dramatic dislocations can present incredibly good buying opportunities to snatch up high-quality preferred securities at dramatic discounts that eventually provide robust capital gains with attractive yields paid along the way. But, for many retirees that are not interested in trading the wild swings of the preferred stock market but instead simply want to clip their coupons and sleep well at night, such wild price deviations can prove devastatingly traumatic, particularly if they are unaware that they may occur at any given point in time and be accompanied by the periodic dividend suspension and/or bankruptcy like those experienced by Lehman Brothers’ preferred stock investors back in 2008. Where Do We Stand Today? To date, the preferred stock universe as a whole continues to hold up fairly well. The asset class as measured by the iShares S&P Preferred Stock Index reached a dividend adjusted all-time high as recently as the end of November. And while the high-0yield bond market has fallen precipitously since the start of December with a more than -6% decline, the preferred stock market is lower by only a fraction at just over -2%. In short, all remains reasonably well. But not entirely so, as several cracks warrant attention. First, preferred stocks started the week on a troubling note. Preferred stocks opened lower and faded throughout the trading day, effectively ending on their lows. This stood in sharp contrast to high-yield bonds that found their footing around 11:30AM today and traded sideways for the remainder of the day. Monday was only one trading day, but investors are well served to monitor this recent development for any continuation to the downside, as this would suggest that the problem in high yield is starting to spread. (click to enlarge) Second, standing back and taking a broader view on preferred stocks, not only is the category now precariously perched on its ultra long-term 400-day moving average, but also as evidenced by its price chart dating back to the summer, it is prone to flash crash pressures like experienced on the wild trading day of August 24. (click to enlarge) Lastly, while the preferred stock universe in general continues to hold up, specific segments of the space are breaking down. During the financial crisis, it was financial preferreds that were obliterated while non-financial preferreds (NYSEARCA: PFXF ) largely held their own. This time around, non-financial preferred stocks from industries such as telecommunications, agriculture, healthcare services, oil & gas, mining and pipelines have deviated from the path of the broader preferred stock universe and have instead latched on to the high-yield bond path lower. (click to enlarge) Thus, while the preferred stock market continues to hold up, it is warranting increasingly close attention going forward, as risk levels are rising both around and within the asset class. Recommendations Much like the high-yield bond and master limited partnership investors that have now gone before, preferred stock investors would be well served to have a heightened level of risk awareness going forward. It may very well be that preferred stocks emerge unscathed from this latest episode of capital market stress. Then again, they may eventually fall victim to the spillover effects that are now dogging related asset classes. Does any of this suggest that the asset class will suddenly head straight to the downside tomorrow? Not at all, for it may take a fair amount of time before the preferred stocks succumb to any downside pressure if at all. And even if the category begins to buckle, it is likely to do so with fits and starts over a more extended period of time. But the fact remains that risk environment surrounding preferred stocks has been elevated from where it has been over the last several years. If nothing else, a heightened degree of price volatility should be expected going forward. Disclosure : This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Where Are The Best Opportunities In Preferred Shares?

Preferred shares belong in every income portfolio. My preference is to use closed-end funds for a preferred shares allocation. In this article I survey all closed-end funds that cover this category with emphasis on identifying leading candidates. Every income portfolio needs an allocation to preferred shares. It will come as no surprise to regular readers when I say I prefer to get mine from CEFs (closed-end funds). It’s my view that there are two areas where CEFs excel relative to competing instruments. One is in the tax-free, municipal bond category and the other is preferred shares. In this article I look at the range of offerings in preferred shares CEFs. There are 16 preferred shares funds listed on cefconnect . Funds Market Cap ($M) Cohen & Steers Ltd Duration Preferred & Income Fund, Inc. (NYSE: LDP ) $663.35 Cohen & Steers Select Preferred & Income Fund, Inc. (NYSE: PSF ) $280.60 Flaherty & Crumrine Dynamic Preferred & Income Fund Inc (NYSE: DFP ) $428.16 Flaherty & Crumrine Preferred Securities Income Fund Inc (NYSE: FFC ) $806.35 Flaherty & Crumrine Total Return Fund Inc (NYSE: FLC ) $185.10 Flaherty & Crumrine Preferred Income Fund Inc (NYSE: PFD ) $139.80 Flaherty & Crumrine Preferred Income Opportunity Fund Inc (NYSE: PFO ) $127.24 First Trust Intermediate Duration Preferred & Income Fund (NYSE: FPF ) $1,315.02 John Hancock Preferred Income Fund Ii (NYSE: HPF ) $405.14 John Hancock Preferred Income Fund (NYSE: HPI ) $502.51 John Hancock Preferred Income Fund Iii (NYSE: HPS ) $529.13 John Hancock Premium Dividend Fund (NYSE: PDT ) $630.31 Nuveen Quality Preferred Income Fund 3 (NYSE: JHP ) $195.68 Nuveen Preferred Income Opportunities Fund (NYSE: JPC ) $878.56 Nuveen Quality Preferred Income Fund 2 (NYSE: JPS ) $1,089.51 Nuveen Quality Preferred Income Fund (NYSE: JTP ) $525.58 CEFs offer powerful advantages in the preferred shares space. First there is leverage. Ok, I know I just wrote an article questioning the value of leverage ( Is Leverage Really an Advantage in Equity Closed End-Funds? ) but the key word in that title is “equity.” Of course preferred shares do fall under the rubric of equity investments, but in my mind they skirt the line between fixed-income and equity, pushing more toward the fixed-income side. So, here I do consider leverage an advantage. And in any case, there is no choice; all 16 preferred shares CEFs are leveraged within a fairly tight range. Effective leverage varies from 28.65% to 33.92%. The median is 33.59%, so the distribution is clearly top heavy as this distribution chart shows. A second advantage is skilled management. This comes at a cost; these funds average 1.7% fees, about a quarter of which is interest cost for leverage. In this category, as in many of the fixed-income categories, managers have tools available that most individuals do not. Leverage is one of them. Another is the ability to use hedging strategies in response to significant increases in long-term interest rates. And a third is access to credit information along with the quantitative tools to use that information to an investor’s best advantage. And a final factor is the opportunity to purchase CEFs at a discount, something not generally possible in other investment vehicles. Every one of these 16 CEFs is priced at a discount. These advantages combine to generate income appreciably greater than a comparable portfolio of preferred shares an individual can assemble, or that one obtains from ETFs. To support that generalization, I preset these data comparing the median CEF to iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) and Preferred Portfolio ( PGX ), the two largest ETFs in the category. Fund Yield PFF 6.13% PGX 6.01% CEF minimum 7.69% CEF median 8.64% CEF maximum 9.01% The median yielding CEF is outpacing PFF by 41% and PGX by 44%. The difference cannot be accounted for by the 33% leverage alone. Management priorities, driven by investor priorities, are a part of the mix; this may show up in CEFs having higher levels of credit risk, for example, as management caters a fund to appeal to investors willing to accept that risk for the higher yields it can bring. Another important factor is premium/discount status. Large premiums and discounts are part of the nature of CEFs, but not a factor in ETFs or open-end mutual funds. The importance of discount shows up in enhanced yields. The median fund’s yield on NAV is 7.82%, well below the median yield at market seen in the table (8.64%). It is the median discount of -9.03% that gets the additional 82 basis point of yield into the investor’s pocket. Of course, the median yielding and the median discounted fund are not necessarily the same fund, I’m just making a point here and using median values to illustrate it. One can readily do the math for individual funds. So what are the yields of our 16 preferred shares CEFs? Here we have yield at market, and yield on NAV. How do funds find their market price levels relative to their NAVs? Obviously there are multiple complex factors, but among the most important is the tendency for the market to drive yields to an equilibrium level via discounts or premiums. This can be seen graphically in the next chart where discount is plotted against distribution on NAV. This trend is seen in every category of CEFs I’ve looked at. There are exceptions, of course, but in general lower NAV yields produce deeper discounts. FFC with the highest NAV yield is the least discounted fund. In fact, discount territory is a relatively unaccustomed place for FFC to find itself in. When I last wrote about preferreds a year ago ( This Fund May Be Your Best Call for Preferred Shares ), I opined that FFC at a discount was a smart buy. That discount was nearly the same as today’s. I continue to feel that way and certainly consider it attractive at its present level. If we accept the tendency to move toward NAV Distribution/Discount equilibrium, the best values should be found among the funds below the trend line. Eliot Mintz had discussed this in relation to tax-free muni-bond CEFs ( Municpal Bond Closed End Funds – How to Find the Best Values ). By this criterion, FPF, JPC, the John Hancock Funds (HPS, HPI and HPF) and PSF merit a close look. A second aspect of CEFs that has a tendency to revert to mean values is Premium/Discount status. This tendency is well documented in the academic research on the subject and can provide a source of alpha. This is measured by Z-Scores. More negative Z-Scores indicates current prices are more discounted than the mean premium/discount. Sometimes one can find buying opportunities among funds that have deeply negative Z-scores. They are also useful in providing an overall picture of trends in a category over time. Here’s how the 16 funds fare for this metric. PDT and PSF are much more discounted today than their 3-, 6- or 12-month means by large margins. FPF, which looked interesting from the Distribution/Discount analysis, has been reducing its discount steadily and now stands about one standard deviation form its three-month mean. The John Hancock funds (HPF, HPI, HPS) show appealing Z-Scores indicating again that they could merit our attention. This report is intended as a broad survey of the preferred shares CEF category. I will be following up with a closer look at the funds that look most attractive in the next installment. We’ll look at management strategies, portfolio quality, sustainability of distributions and other factors that go into choosing a fund. Among my “best bets” that I’ll be covering are FFC, which I consider the best of the field but possibly not a buy at this time; FPF; and the John Hancock funds. Meanwhile I and other readers would certainly appreciate hearing from readers regarding their opinions on the subject of preferred shares funds.