ET - PFFA: Impressive Performance From This 10% Yielding Fund

2023-08-22 13:50:40 ET

Summary

• We shifted from a "buy" to a "neutral" rating on PFFA due to a changing risk-reward structure when we last covered the fund.
• The fund has seen impressive asset expansion and has maintained its distribution despite cuts in other funds.
• We examine the current setup for this 10% yielder.

On our last coverage of Virtus InfraCap U.S. Preferred Stock ETF ( PFFA ) we moved to the other side of the fence after our bullish calls and felt that the risk-reward structure had changed a bit. This was a downgrade from a "buy" to a "neutral". Staying out of a high income stream for almost seven months is not generally pleasant as investors miss the regular distributions. But so far this has worked. If you took the money and put it into a money market fund, you would have beaten PFFA in total returns by about 5% or close to 10% annualized.

That said, the fund has been impressive in a few different ways and the lower price can often swing the vote in some close calls. This has been despite our macro calls for interest rates panning out as expected and providing a stiff headwind to the fund. Let's see if this deserves a shift.

The Fund Distributions

PFFA has managed to collect an impressive amount of assets for an actively managed fund and on last check Jay Hatfield ran over $600 million. This may sound less in relation to what passive ETFs collect, and it definitely is, but in the active arena, within preferred shares, this is pretty good. PFFA has now reached levels that ( AMZA ) (run by the same team), obtained at its peak.

What has driven this impressive asset expansion has been the distribution. Yes, the distribution was cut during COVID-19 from 19 cents per month to 15 cents a month, but it has risen nicely off that to 16.5 cents a month. In contrast, most closed end funds in this space have been cutting relentlessly. Below we show Flaherty & Crumrine Total Return Fund ( FLC ) which has cut seven times since 2021.

Nuveen Pref & Income Securities ( JPS ) has cut four times and the reduction in distribution percentage is similar to FLC. That has been the fate of all those that wielded the double-edged sword of leverage into the most aggressive rate hike cycle, but PFFA has dodged this.

What Worked

PFFA has been one of the more volatile funds that we follow, especially relative to its sector. But that volatility has paid off and the fund has pummeled its benchmark over every single timeframe.

In recent times the fund has favored high coupon and floating rate preferred shares over fixed ones. The fund has taken on far more credit risk (going deep into junk) and taken less interest rate/duration risk on a relative basis.

One example here would be the NuStar Energy L.P., 9.00% Series C Fixed to Float Cumulative Redeemable Perpetual Preferred Units (NS.PC). Yield started floating at LIBOR plus 6.88% from December 15, 2022. The fund held this security from well under par and the result has been a big capital appreciation and a 13% plus yield on the price they got in at. Even the Crestwood Equity Partners LP preferred shares ( CEQPPR ), which show as the number two holding, have done remarkably well compared to most other fixed rate preferred shares and got an extra boost when Energy Transfer LP ( ET ) agreed to buy out Crestwood Equity Partners LP ( CEQP ).

Macro Outlook

Making money via leverage has been tough and it is likely to get tougher with risk-free rates screaming higher. PFFA used about 30% leverage on last check and the weighted average interest rate paid for the six months ended April 30, 2023 was 5.45%.

Interest is charged at the Overnight Bank Funding Rate (“OBFR”) plus an additional percentage rate on the amount borrowed. The Agreements have an on-demand commitment term. For the period ended April 30, 2023, the average daily borrowings under the Agreements and the weighted average interest rate were $147,209,126 and 5.45%, respectively.

Source: PFFA Semi-Annual Report

Today, we are likely close to 7%. You can probably remember the good old days when most preferred shares yielded well under 7% and now the borrowing costs are higher than that. In this climate PFFA has to fund a 10% plus yield net of expenses. This will be tough and the only way to do it is to stick with the high floating rate preferreds that have double digit yields currently. Does this work out in the current environment?

It is tough to say, as the economy has remained more resilient to the interest rate hikes than what we would have wagered at this point. But you have to respect the lag. Note that this chart below is from May. Since then bank lending standards have tightened further (chart above), while high yield spreads have remained comatose.

So the risk is there and it is high that the leverage will come back to bite at an inopportune time.

Verdict

There is no question here that PFFA has delivered more than what you could have got from preferred funds, leveraged or unleveraged. But the game of risk management is about what you want to own into a potential credit event. For example, if you bought PFFA just before COVID-19 in February 2020, you would be down, still, 28.06% on price and come remarkably close to breaking even including all distributions, after 42 months.

We do like fixed income here, relative to equities and it is rare that you get to find so many opportunities where debt gives you 7% yields with virtually no risk. But even in that sphere the more you try to generate, the more risk you take. Maybe it works out seamlessly where inflation subsides and the Fed cuts gradually. With these levels of unemployment though, the more likely outcome is that things break badly as inflation reaccelerates or the economy slips into a recession.

As we said before, respect the lag.

We might be interested in a non-leveraged version of PFFA, but the current setup is just not one we can get behind right now. We continue to rate it neutral and look for opportunities in individual names.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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