JPC - Bottom Fishing Preferred Stocks With 8% Yields: JPC

2023-12-28 07:35:00 ET

Summary

• I love buying out-of-favor income, so I get big gains when it's in favor again.
• Fixed income has been beaten down relentlessly by rate hikes and inflation.
• Today, you can unlock massive income from this sector to enjoy for decades to come.

Co-authored by Treading Softly

Imagine if you were in a large shopping mall on Black Friday, but refused to buy anything because it was on a massive sale.

"I don't want that large-screen TV – It's 50% off. Something must be wrong with it!"

"I don't want that oven. It's 25% off, and that must mean that it's low quality!"

"Other people are willing to pay full price for other products, I'm not gonna buy this on a sale."

Sounds ridiculous, right? It seems that these days, everyone is looking for a deal. Everyone is looking for a sale. People are cutting coupons and trying to pinch pennies where they can. Yet, when it comes to the market, investors so often have a completely other mindset. The more expensive it is, the better they think it is. They're not willing to buy things when they're out of favor or on sale. They're only willing to buy things sometimes at the highest premiums they've ever seen. This is a common reason why the average investor so grossly underperforms a simple market-wide ETF. While many people claim that they espouse the view of "capital preservation" or "buying low and selling high," few successfully perform that task, and therefore, buying a passive market-wide ETF like the SPY provides them with better returns because it removes their emotions from the equation.

This past year has been absolutely brutal for the fixed-income sector with rapidly rising rates, and thus, investors have fled the sector because it was getting beaten up. Now, many of us are afraid to return to the sector because it's on sale. So, just like the Black Friday shopper above, they see the price tag and instead of buying it at a discount, they simply keep on walking, worried that it must be wrong for some reason.

Today, I want to look at a fund that allows you to gain exposure to a sector that's vastly on sale. So that way, you could earn some outstanding income from it.

Let's dive in.

A Newly Combined Fund

Nuveen Preferred & Income Opportunities Fund ( JPC ), yielding 8.5%, is a CEF (Closed-End Fund) that recently saw a merger combining three Nuveen funds: JPS, JPT, and JPC. The fund invests primarily in preferred equity and other fixed-income investments. We came into ownership of JPC through JPS, a move that led to a slight increase in our dividends. Then, with the latest announcement, JPC raised its dividend 8% to $0.0475/month.

This is a welcome change from the recent trend, which has been a series of dividend cuts. The phrase "dividend cut" strikes terror into the heart of income investors. I frequently say that dividend cuts from closed-end funds are the least concerning type of cut. Why?

When we analyze investments, we are often looking at businesses that produce something or provide a service. They build some kind of infrastructure, attract customers, and manage their costs and balance sheets. Over time, a "good" company will develop a larger infrastructure, allowing it to expand its customers and make higher profits. We expect that companies will generally see higher profits year after year. When they start seeing their profits decline, we start seeing dividend cuts.

In this sense, a dividend cut is often a reflection that something is "wrong" with the core strategy of the business. Maybe their product isn't in demand anymore, maybe they were overextended on their balance sheet, or maybe they are doing a poor job executing their business plan. We then have to figure out if whatever is wrong can be fixed, or if the business is so broken that it is no longer worth operating at all.

CEFs are different. They don't build infrastructure, and they don't develop anything. They take the capital they have and invest it in a particular sector or strategy. The distributions that a CEF pays will represent somewhere around 100% of the total returns of the CEF's investment portfolio. The reason is that they are required by tax law to distribute substantially all of their income and capital gains. Therefore, it is unreasonable to expect a CEF to "grow" year after year because whatever gains they have will be distributed to shareholders. We also know that returns from the stock market are not consistent. Here is SPY's annual returns since 1994: Source

Big years, modest years, and years of losses. This is what all investors have to face.

To provide stability, CEFs will often have a "managed dividend policy" where they set the dividend at a level that management expects will match the mid to long-term total returns of the portfolio. It will sometimes be "underpaying" and other times "overpaying" what the portfolio returned in a particular year.

In the long run, the total return investors receive from a CEF will approach the total return of the underlying portfolio through some combination of NAV and dividends. If the manager decides to overpay in a down year, that will reduce NAV. If the manager underpays during an up year, NAV will increase. Whether the manager decides to have an aggressive dividend policy or a more conservative one, it doesn't make a substantial difference in the total return. Managers who are quick to reduce the dividend will have funds that maintain NAV better than managers who are willing to overpay.

Therefore, the primary question investors should ask themselves when buying any CEF is whether they want more exposure to the sector. Second, they should ask whether the manager has a history of outperforming other options in their sector.

JPC invests in preferred equity, primarily institutional preferred, with a $1,000 par value. The bulk of its holdings are banks and insurance companies. Source

We have frequently discussed the virtues of preferred and the great opportunity in preferred today as prices have declined primarily due to higher interest rates. When interest rates go up, the price of all fixed-income investments comes down. When interest rates go down, that is a tailwind that lifts the price of fixed-income investments.

So the answer to the first question is straightforward – yes, we want more exposure to preferred equity. We are very bullish on preferred looking forward. JPC is a particularly good fit for our Model Portfolio because the Model Portfolio has over 40 individual preferreds, but has very little exposure to banks and only modest exposure to insurance companies. As a result, an investment like JPC provides us with more exposure to preferred, while also improving our diversification by holding a lot of preferred that are not already part of our portfolio.

The second question is whether JPC outperforms other options. The closest ETF is iShares Preferred and Income Securities ETF ( PFF ), and we can see that JPC has outperformed.

In large part, this outperformance is because JPC uses leverage – currently at 37% of gross assets. JPC's leverage is a combination of debt, reverse repos, and variable rate preferred.

Leverage provides the benefit of boosting income, which is why JPC can pay a much higher yield than PFF. However, it also increases volatility. As you can see on the total return chart above, JPC's price movements go in the same direction as PFF, but it swings up and down more dramatically.

Over the past two years, JPC has seen two major headwinds. First, rising interest rates drove down the prices of fixed income, resulting in lower total returns. Second, higher interest rates drove up the cost of short-term borrowing, which decreased the effectiveness of using leverage for higher cash flow. As a result, management decided that they didn't want to be selling assets at poor prices to fund the dividend. Instead, they decided to reduce the dividend, allowing the fund to hold more assets while it waits for the preferred market to recover.

It is becoming increasingly likely that rates have peaked and become increasingly biased toward coming down. This will drive NAV back up, and we are starting to see a beginning of the dividend coming back up as well.

Conclusion

With JPC, we can gain exposure to the heavily oversold fixed-income sector, but specifically, the subset of financial or insurance preferred securities, many of which had rock-bottom yields at par and thus sold off the heaviest. By using a CEF, we can leverage the experience and skills of the portfolio management team while accepting a payout rate that may vary more than buying preferred securities directly.

When it comes to retirement, I like things to be as simple and straightforward as possible. That's why, when I designed the Income Method, it focused on generating a high level of current income today, to be able to easily judge how you're doing on your retirement planning. If you know you need $100,000 a year in retirement and your portfolio is generating $70,000 a year in dividends, you know that you have $30,000 to make up, either through Social Security, another passive income stream or by increasing the amount of dividends your portfolio produces over time. It gives you an easy way to spot-check how your retirement planning is going. When you're in retirement, the last thing you want to have to worry about is constantly juggling different preferred securities or bonds. You want a portfolio that is clean and straightforward. This fund can help you gain exposure to a sector that many people may otherwise avoid because of confusion and allows you to earn great income from it.

That's the beauty of my Income Method. That's the beauty of income investing.

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