LDP - LDP: Internals Look Strong For This 9.2% Yielding Preferred CEF

2023-10-12 08:34:54 ET

Summary

• Cohen & Steers Limited Duration Preferred and Income Fund trades at a 9.2% current yield and an 11% discount.
• LDP has a portfolio allocation mostly to institutional preferreds, with over 70% allocated to financials like banks and insurance companies.
• LDP's net income has fallen by nearly 30% since its peak at the end of 2020 due to rising leverage costs, but its interest rate swap hedges have helped offset.

In this article, we take another look at the Cohen & Steers Limited Duration Preferred and Income Fund (LDP). The fund has recently released its shareholder report and we take this opportunity to update our analysis. LDP trades at a 9.2% current yield and an 11% discount.

Quick Snapshot

LDP has a fairly typical allocation for a preferred CEF. Its portfolio is allocated mostly to institutional preferreds with over 70% of the portfolio allocated to financials like banks and insurance companies.

Its portfolio is about half in investment-grade stocks. It has leverage of 35%.

Income Update

If we take a look at the fund's net income profile, we see that, on the face of it, the net income trajectory of the fund is not exactly inspiring. In fact, it's fallen by nearly 30% since its peak at the end of 2020.

The culprit is something we have discussed ad nauseam - rising leverage costs. Typically, credit funds have also suffered from deleveraging however this wasn't the case with LDP (though it was to a small extent with its sister fund PTA) because of its lower-beta profile.

This lower-beta-profile of LDP has been a function of two things - a relatively modest starting leverage (under 30% at the end of 2021 and on the low side in the Cohen & Steers preferreds suite) and a lower duration stance. For example, while the LDP duration is 3.3, it is 4.6 and 5.5 for its sister funds PTA and PSF. This is very much what has made it the best-performing preferred CEF in total NAV terms this year given the continued rise in Treasury yields.

However, as readers of our article on the sister fund PTA are well aware of, LDP also has a portfolio of interest rate swaps that mostly offsets the rising interest expense.

The fact sheet states this fairly succinctly. Whereas nearly all leveraged CEFs are paying around 6% on their leverage, LDP gets by with 2.2%. This is a weighted-average rate on its overall leverage which is composed of 85% fixed-rate financing at 1.6% and a 15% credit facility on which it pays 5.9%.

The "magic" behind an ultra-low 2.2% rate on most of LDP's leverage has to do with its interest rate swap hedges. The reason we don't see the swap cashflows in net income is because, as off-balance sheet derivatives, swaps don't generate GAAP income. We can, however, see the value of the swaps portfolio in the shareholder report which had a mark-to-market of $28m as of the last report.

The key point here is that investors are not seeing these unusually low hedge costs in net income. So while on paper net income has fallen over the last couple of years, in reality it has been much more stable.

Another attractive feature of the portfolio is that many preferreds are coming up to their reset date (highlighted in a portfolio extract below) where the coupon will either switch to a much higher (in nearly all cases) coupon or the stock will be redeemed. This is a win-win as a redemption will typically result in a small return boost and will likely allow the fund to reinvest the capital in a higher-coupon security, boosting net income (and likely portfolio yield as well if the return boost is significant).

Often it helps to get a top-down as well as bottom-up understanding of a fund's income profile. If we use a figure of 7.7% for the fund's portfolio yield (where Nuveen pegs the preferreds sector yield) then, once we go through the CEF income sausage factor below, we come out with a portfolio yield on price of 10.9% - very attractive in the current environment for a high-quality portfolio.

LDP trades at a double-digit discount - slightly wider of the sector average.

Its recent distribution cut means its discount has pushed wider relative to its sister fund PTA which we have held previously.

At this point LDP generates a portfolio yield on price that is roughly 0.5% above that of PTA which is primarily due to its lower management fee and wide discount. This is why we currently favor LDP over PTA in the sector.

Takeaways

We continue to view LDP as one of the best preferred CEFs in the current environment. Its unusually low cost of leverage, low management fee and wide discount allow it to drive a high level of underlying portfolio yield in the preferreds CEF sector. It is particularly attractive for investors looking to shorten up on duration exposure and/or to increase exposure to institutional preferreds which continue to trade at wider spreads than their retail counterparts.

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