MSD - PCF: Good Strategy And Price But A Few Concerns

2023-03-20 17:44:08 ET

Summary

• Investors are desperately in need of income as the high inflation has made it ever more difficult for us to sustain our standard of living.
• High Income Securities Fund invests in a portfolio of business development companies, closed-end funds, and preferred stock to provide a very high yield.
• The PCF closed-end fund filed its most recent SEC document late and is generally not as transparent with its investors about its holdings as it should be.
• The fund paid a sizable portion of its distribution out of new money last year and had to cut the distribution back in January.
• The fund is currently trading at a fairly attractive valuation relative to the net asset value.

Without a doubt, one of the biggest challenges facing the average American today is the pervasive inflation that has swept the nation. The current cost-of-living crisis is the worst in more than forty years, as there has not been a single month over the past year in which the consumer price index was not at least 6% higher than in the prior-year quarter:

This has caused hardship for many Americans, particularly those at the lower end of the income scale. After all, two of the items that have seen the greatest cost increase have been food and energy, which are generally considered to be necessities. As such, we have seen a surge in people seeking out additional work. A recent Prudential Pulse survey stated that 81% of Generation Z members and 77% of Millennials have either entered the gig economy or are considering doing so in order to increase their incomes beyond what they are able to get from their regular jobs. This increase in temporary work is probably why the job market continues to be strong despite massive layoffs in the technology sector. I discussed this in a recent blog post . In short, Americans are desperate for income.

Fortunately, as investors, we have other methods that we can employ in order to generate the additional income that we need to cover the rising cost of living and do not need to resort to taking on second jobs. This is because we are able to put our money to work for us and earn income that way. One of the best ways to do this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income. These funds are admittedly not particularly well-covered in the investment media or well-followed by investors but they should be as they provide easy access to a diversified portfolio of assets that can usually produce a higher yield than the underlying assets actually possess.

In this article, we will discuss the High Income Securities Fund ( PCF ), which is one fund that can be used to boost our portfolio incomes. As of the time of writing, the fund boasts an impressive 11.58%, which will certainly appeal to income-focused investors. Unfortunately, that yield is sufficiently high that it is a sign that the market expects that the fund will be forced to cut its distribution in the near future. As regular readers are likely aware, I have discussed this fund in the past but as a few months have passed, there have been some changes in the macroeconomic environment as well as in the fund itself. This article will specifically focus on these changes as well as specifically discuss the sustainability of the distribution.

About The Fund

As I pointed out in my last article, the fund’s webpage provides pretty much no information about the fund other than copies of its annual and semi-annual reports. In fact, the fund’s objective is not even provided on the webpage. Fortunately, CEF Connect’s webpage on this fund is a bit more informative. It states the following about the fund:

“The Fund’s investment objective is to provide a high current income as a primary objective and capital appreciation as a secondary objective. The Investment Committee currently manages the Fund’s assets with a focus on discounted securities of income-oriented closed-end investment companies and business development companies. The Fund’s objective is pursued by primarily investing, under normal circumstances, at least 80% of its net assets in fixed-income securities, including debt instruments, convertible securities, and preferred stocks.”

This is, admittedly, not exactly what might be expected from the name of the fund. This is not a fixed-income fund as might be assumed. In fact, currently the largest weighting in the fund’s portfolio is to common stock in other investment companies:

Of these positions, the majority are other closed-end funds as opposed to business development companies. According to the fund’s most recent financial report , 38.37% of the fund is invested in other closed-end funds. This leaves 19.41% invested in business development companies. The remainder of the fund’s assets is invested in directly held securities, primarily preferred stocks. However, the fund’s actual exposure to fixed-income investments is undoubtedly higher than the above figure might indicate as it seems very likely that the closed-end funds in the portfolio are invested in fixed-income securities. A look at the closed-end funds that are included in the fund’s portfolio reveals a combination of fixed-income funds and equity closed-end funds. Here are a few notable holdings:

There are also a number of funds that the High Income Securities Fund holds in its portfolio that invest in a combination of common equity and fixed-income securities. Interestingly, there are no option-income funds listed among the fund’s holdings, which is curious as option-income funds can be among the most reliable funds for income investors during flat or weak markets like the one that we have right now. In short, though, there is no real way for us to determine exactly what percentage of this fund is ultimately invested in fixed-income securities versus common equities.

That is important because of interest rate risk. As everyone reading this is no doubt well aware, the Federal Reserve has been aggressively raising interest rates and tightening the monetary environment since March of 2022. We can see this by looking at the federal funds rate, which was at 0.08% back in February of 2022 but sits at 4.57% today:

This has devastated the bond markets since bonds and other fixed-income securities are priced based on interest rates in the economy. It is an inverse relationship, so when interest rates increase, bond prices decrease. Thus, the value of the fixed-income securities held by the High Income Securities Fund or by a fund that it is invested in has declined over the past year. That would naturally have a negative impact on the fund’s portfolio as it would cause it to suffer unrealized or realized losses. Unfortunately, despite the recent troubles in the banking industry, there has been no indication that this situation will improve anytime soon. Thus, investors might want to prepare for the fund’s market price to struggle for a while longer.

For some reason, the fund did not release its quarterly report on its fund holdings back in November. There was a late filing made to the SEC that is available on the agency’s website , but that document is not particularly insightful. It would have been nice to get a summary provided on the website as the fund has historically provided. Curiously, the fund did not even include a list of its largest positions in the annual report, which likely explains why CEF Connect and even Morningstar only have information about the fund’s positions that are more than a year old. That certainly does not look particularly good for the fund’s management team in terms of transparency. It would be nice to get some sort of update from the fund sponsor regarding the fund’s portfolio, particularly considering that the market environment is very different than it was a year ago due to the Federal Reserve’s monetary tightening policy. Hopefully, we will get some sort of an update when the fund releases its semi-annual report. The semi-annual report should correspond to the six-month period that ended on February 28, 2023, but the SEC has historically not received the document until May so we might have to wait a while for it. The fact that the latest quarterly update was filed late though means that I am cautious about stating when that updated document will be available.

Fortunately, the fund did state that it had a 74.00% annual turnover in 2022. The reason why a fund’s turnover is important is that trading stocks or other assets costs money that is billed directly to the shareholders of the fund. This creates a drag on the portfolio’s performance that makes management’s job more difficult. This is because the fund’s management will need to generate sufficient excess returns to cover these expenses as well as deliver a sufficiently high return to satisfy the fund’s investors. That is a task that very few management teams manage to consistently accomplish. While that is one reason why many closed-end funds fail to match the performance of similar index funds, there is no appropriate index to compare this fund to. This fund is fairly unique and as such, the use of active management is pretty much necessary here.

Leverage

In the introduction to this article, I stated that closed-end funds like the High Income Securities Fund have the ability to generate a higher yield than the underlying assets possess. One method to accomplish this that is employed by this fund is the use of leverage. In short, the fund borrows money and then uses those borrowed funds to purchase other closed-end funds, business development companies, and other assets. As long as the purchased assets have a higher yield than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. This fund is capable of borrowing at institutional rates, which are substantially lower than retail rates, so this will usually be the case.

However, the use of debt in this fashion is a double-edged sword. This is because leverage increases both gains and losses. As such, it is important to ensure that the fund is not employing too much leverage since that would expose us to too much risk. I generally do not like to see a fund’s leverage exceed a third as a percentage of its assets for this reason. As of the time of writing, the High Income Securities Fund’s levered assets comprise 1.06% of the portfolio. As such, this fund seems to be using relatively minimal leverage itself, however, it is important to keep in mind that other closed-end funds and business development companies almost certainly use leverage so the effective leverage here is higher than we might think by simply looking at the low figure for this specific fund.

Distribution Analysis

As stated earlier in this article, the primary investment objective of the High Income Securities Fund is to provide its investors with a high level of current income. In order to accomplish this, it invests mostly in closed-end funds and business development companies, which boast very high yields themselves. The fund generally passes through the distributions that it receives to its investors, which is the basic business model of any closed-end fund. Thus, we can assume that the High Income Securities Fund will have a fairly high yield itself. That is certainly true as the fund currently pays a monthly distribution of $0.0604 per share ($0.7248 per share annually), which gives it an 11.58% yield at the current price. Unfortunately, the fund has not been particularly consistent in its distribution over the years. In fact, it has fluctuated quite a lot over the past few years:

The fact that the fund’s distribution tends to vary considerably over time will likely be something of a turn-off to those investors that are looking for a stable and secure source of income that can be used to pay their bills or otherwise finance their lifestyles. However, it is important to keep in mind that anyone purchasing the fund today will receive the current distribution at the current yield. As such, the fund’s history is not exactly the most important thing. The most important consideration for new investors is the fund’s ability to maintain its current distribution. That may be especially important today since generally speaking, any time an asset has a yield exceeding 10%, it is a sign that the market expects that the distribution will be cut in the near future.

Unfortunately, we do not have a particularly recent document to consult for the purpose of examining the fund’s distribution sustainability. As of the time of writing, the fund’s most recent financial report corresponds to the full-year period that ended on August 31, 2022. As such, it will not provide us with any insight into the fund’s performance over the past seven months. That is disappointing since numerous things happened during that timeframe. However, the worst shock to the market came in the first half of 2022 when the Federal Reserve began its monetary tightening regime, so at least we can get some insight into how the fund weathered that event from this report. During the full-year period, the High Income Securities Fund received $6,451,957 in distributions and $74,607 in interest from the investments in its portfolio. This gives it a total income of $6,526,564 during the period. The fund paid its expenses out of this amount, leaving it with $5,111,572 available for the shareholders. As we might be able to guess, that was nowhere near enough to cover the $14,452,651 that the fund actually paid out during the period. At first glance, this will likely be concerning as the fund had insufficient net investment income to cover its distribution over the period.

However, a fund like this does have other methods that it can employ in order to obtain the money that it needs to cover its distribution. For example, it might have been able to earn capital gains from its assets. In fact, and perhaps surprisingly, the fund did indeed manage to achieve this during the year. It reported net realized gains of $5,260,182, although this was offset by $13,481,870 net unrealized losses. However, the fund’s assets increased by $49,673,285 over the course of the year. This was certainly not from its operations, though. Instead, the fund issued $67,236,052 worth of new common shares during the period. This new capital offset the fund’s losses and partially funded the distribution. However, as everyone reading this certainly knows, a fund cannot sustain its distribution indefinitely by issuing new shares and paying out the money to existing investors. This probably explains why the fund cut its distribution back in January as it was unable to sustain the old payment. It is probably best to wait until the fund releases its next financial report before buying shares, to ensure that it actually can afford the distribution at the new level.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a sure-fire way to generate a suboptimal return on that asset. In the case of a closed-end fund like the High Income Securities Fund, the usual way to value it is by looking at the fund’s net asset value. The net asset value of a fund is the total current market value of all the fund’s assets minus any outstanding debt. It is therefore the amount that the fund’s shareholders would receive if it were immediately shut down and liquidated.

Ideally, we want to purchase shares of a closed-end fund when we can acquire them at a price that is less than the net asset value. This is because such a scenario implies that we are buying the fund’s assets for less than they are actually worth. That is, fortunately, the case with this fund today. As of March 17, 2023 (the most recent date for which data is available as of the time of writing), the High Income Securities Fund had a net asset value of $7.24 per share but the shares currently trade for $6.25 per share. This gives the fund’s shares a 13.67% discount to net asset value at the current price. This is quite a bit more attractive than the 9.61% discount that the shares have averaged over the past month. Thus, the price certainly looks reasonable today.

Conclusion

In conclusion, investors are desperately in need of income today to help offset the impact that today’s incredibly high rate of inflation has had on our ability to maintain our standard of living. The High Income Securities Fund certainly looks like a reasonable way to get this income, as its strategy of investing mostly in closed-end funds, business development companies, and preferred stock is quite solid. The fact that High Income Securities Fund trades at a discount to net asset value is also nice. Unfortunately, the fact that the management team seems to have difficulty getting updates through to investors in a timely manner is quite concerning, as is the fact that the fund depended on new investment capital coming in to pay its distribution last year. As such, I would advise waiting until we get a copy of the semi-annual report before buying in, as hopefully, that document will be able to address our concerns about the distribution.

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