HPF - HPF: Attractive 8.5% Yield But May Not Be Sustainable
Summary
- The HPF fund holds a portfolio of preferred stocks and corporate bonds.
- The fund pays an attractive 8.5% distribution yield.
- However, looking at HPF's long-term performance, I am concerned with its long-term declining NAV and distributions.
Recently, I wrote an article reviewing the John Hancock Preferred Income Fund ( HPI ). This article takes a look at HPI's sibling fund, the John Hancock Preferred Income Fund II ( HPF ). Structurally, the HPF fund is very similar to the HPI fund. They both provide exposure to preferred stocks and corporate bonds with similar asset allocations and historical returns.
The two funds also share similar faults. Although the HPF pays an attractive 8.5% distribution yield, I worry its distribution may not be sustainable in the long run as it is far above the fund's long-term average returns.
When I look at high yield fund investments, I always check the fund's long-term NAV progression and historical distributions. I want to avoid amortizing 'return of principal' funds where the high yield is funded by returning principal, as that could be a recipe for losing both principal and income when/if the fund has to cut its distributions.
Fund Overview
The John Hancock Preferred Income Fund II is a closed-end fund ("CEF") focused on high current income and capital preservation. The fund focuses on preferred stocks and preferred convertible securities.
The HPF fund has $368 million in net assets with 38.4% effective leverage (Figure 1). The fund charged a 1.82% net expense ratio, contractually set until July 2024.
Figure 1 - HPF fund facts (jhinvestments.com)
What Are Preferred Stocks?
Preferred stocks share characteristics of both bonds and common stocks. Like bonds, preferred stocks typically pay a yield (can be either fixed or floating). Unlike bonds, preferred dividends can be skipped by a company in distress without putting the company into credit default, although this practice is highly frowned up. Preferred yields are also typically higher than bond yields, as it needs to compensate investors for a lower priority claim on the assets.
Like common stocks, preferred stocks can trade on a public exchange. However, the appreciation potential in preferred stocks is usually limited, as preferred stocks typically have call provisions allowing the company to redeem them at a certain price. Preferred stocks also usually have no voting rights when it comes to corporate matters.
Preferred stock sit between bonds and common equity within a company's capital structure (Figure 2). In the event of a corporate bankruptcy, preferred shareholders have a superior claim on assets compared to common shareholders, but are subordinated to bondholders.
Figure 2 - Preferred stocks in capital structure (corporatefinanceinstitute.com)
Portfolio Holdings
The HPF fund has 136 positions with an effective duration of 3.5 years. Figure 3 shows the fund's asset allocation as of December 30, 2022. 42% of the fund was invested in corporate bonds and 54% was invested in preferred stocks. HPF's asset allocation is virtually identical to the HPI fund.
Figure 3 - HPF asset allocation (jhinvestments.com)
Returns
Figure 4 shows HPF's historical returns. The HPF fund had a strong rebound in January, returning 11.6% YTD. However, longer-term returns are modest, with 3/5/10Yr average annual returns of 0.3%/4.1%/5.6% respectively to January 31, 2023.
Figure 4 - HPF historical returns (morningstar.com)
HPF's returns are virtually identical to that of its sibling fund, the HPI (Figure 5).
Figure 5 - HPI historical returns (morningstar.com)
Likewise, HPF suffers from the same volatility issue as the HPI fund. On a 3Yr basis, the HPF fund has volatility of 22.1%, equivalent to an equity fund like the SPDR S&P 500 ETF Trust ( SPY ). This causes the HPF fund to lag its peer group, the Preferred Stock category on Morningstar, in both returns and risk (Figure 6).
Figure 6 - HPF his elevated volatility (morningstar.com)
Distribution & Yield
The HPF fund pays a monthly distribution of $0.1235 / share or a forward yield of 8.5%.
Comparing between the fund's 10Yr average annual returns of 5.6% and a forward distribution yield of 8.5%, it appears the HPF fund is another example of 'return of principal' funds where the fund does not earn its distributions in the long-run.
Visually, this is confirmed by a long-term downtrend in the fund's NAV, indicating income and capital appreciation has not been sufficient to fund its distribution so the fund has to dip into its NAV (Figure 7).
Figure 7 - HPF NAV has been on long-term decline (Author created with chart from morningstar.com)
We can also confirm by looking at the fund's long-term distribution history, which has been slowly declining from $2.38 / share in 2003 to $1.48 currently (Figure 8).
Figure 8 - HPF's historical distributions (Seeking Alpha)
Readers who want to understand more about the 'return of principal' concept are encouraged to look up the whitepaper titled 'Return of Capital Demystified' by Eaton Vance or refer to one of my recent articles .
HPF vs. HPI, Which One To Own?
Since the HPF fund and the HPI fund are virtually identical in their portfolio composition and historical returns, I don't believe there is any advantage to owning one over the other. Note, both funds are managed by the same management team led by Mr. Joseph Bozoyan.
On the other hand, I believe a better question to ask is whether investors should own either fund in the first place? In my HPI article, I compared the HPI fund to the Invesco Variable Rate Preferred ETF ( VRP ) and concluded the VRP was superior on most of the metrics that I care about. Figure 9 updates the comparison table and adds the HPF fund.
Figure 9 - HPI vs. HPF vs. VRP (Author created with returns and risk from morningstar and fund details and distribution from Seeking Alpha)
The strong rebound in YTD results have improved HPI/HPF's 5Yr return figures, which are now superior to VRP's. This is one problem with fund comparisons, as they are a snapshot in time and results can vary depending on the lookback period.
However, I think the general conclusion that the VRP fund is a superior investment product is still valid. First, while nobody can predict fund returns, what is immutable is the fees charged by a product. The VRP charges an expense ratio of 0.5% vs. 1.81% for HPI and 1.82% for HPF.
Second, in my opinion, the volatility in HPI/HPF's returns highlight a weakness in its strategy. Naively, investors may simply compare return figures and conclude that higher is better. However, with HPI/HPF's volatility almost double that of VRP's, the holding experience may be vastly different. VRP shines in having superior returns and lower risk than the peer group Preferred Stock category (Figure 10). This allows investors to hold the investment for longer while sleeping well at night.
Figure 10 - VRP has superior return vs. risk characteristic (morningstar.com)
Finally, perhaps most importantly for long-term investors, the HPI/HPF fund appears to be amortizing 'return of principal' funds that pays a distribution higher than its long-term returns. This is problematic because long-term investors may see declines in both their invested principal (NAV) and income (distributions).
Conclusion
The HPF fund from John Hancock is very similar to its sibling fund, the HPI. Both provide exposure to preferred stocks and corporate bonds. Although the HPF pays an attractive 8.5% distribution yield, the distribution may not be sustainable in the long run as it is far above the fund's long-term average returns.
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HPF: Attractive 8.5% Yield, But May Not Be Sustainable