PSF - Preferred Closed-End Funds: Out Of The Frying Pan Into The Fire

2023-04-11 15:54:06 ET

Summary

• Today, I wanted to take a broader look at the preferred closed-end fund space.
• After struggling for most of the last year due to rapidly-rising interest rates, the latest banking failures sent preferred CEFs spiraling.
• A mixture of leverage and exposure to contingent convertible securities amplified these declines.

Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on March 28th, 2023.

Out of the frying pan into the fire seems to be an appropriate phrase for the preferred closed-end fund space. This area of the market has been struggling in the last year due to aggressively rising interest rates. Rising interest rates have a negative impact in two ways on these funds.

First, the underlying portfolios that pay mostly fixed-rate dividends see their values reduced. Second, all of the funds in this space utilize leverage. The cost of this leverage has ballooned as they borrow primarily at a floating rate.

That being said, some funds had hedged against the rising rates with interest-rate swaps and some fixed-rate borrowings. More broadly, though, this had done little to hedge against declining portfolio values.

Below is a comparison between the 10-year Treasury Rate and the iShares Preferred and Income Securities ETF ( PFF ). Now, even as yields have backed off, we haven't seen a recovery in PFF. Of course, we know why the price of PFF has been declining more recently, even as rates dropped sharply, is due to the bank collapses.

A significant number of preferreds are issued by financial institutions, so as the bank crisis has come about, there has been significant pressure on the valuations of these securities. That includes even more than just the SVB Bank and Signature Bank preferred, as uncertainty has spread like wildfire. Thus, a large rush into safer assets such as Treasuries to drop their yields but also fleeing from preferreds to see their prices drop.

Even more so working against closed-end fund preferreds was their involvement with contingent convertible securities (AKA CoCos, AKA AT1 bonds.) That and the leverage we mentioned saw the declines in CEFs drop significantly further. Credit Suisse ( CS ) saw their CoCos wiped out, just like fear spread to other financial preferred valuations, CoCos saw their values drop. CS is being bought out by UBS Group ( UBS ) but saw the complete wipeout of the CoCos. Which is exactly what these types of positions were designed for. They were designed to be wiped out if needed and act as loss absorbers.

Here's a look at the performance of the preferred CEFs in the last year. We can see the amplified downside relative to PFF. Not a single one performed better than this passively managed non-leveraged ETF in the last year, as would be expected to be the case. However, for most of these funds, the detraction came specifically in the last month, when we've seen the greatest volatility spike up.

These types of securities are supposed to be safer than equities, which is why they often run with higher amounts of leverage in the first place. It was simply bad news going to worse news for the preferred space. Most of these funds hold a material amount of their portfolio in what is considered investment-grade securities, too. Speaking of leverage, there could be some cases where we see some of these leveraged funds forced to de-leverage their portfolios. That could mean some permanent damage to these funds as it'll be fewer assets to recover with going forward.

As an example of the CoCo and bank failure exposure, we can look at Cohen & Steers Tax-Advantaged Preferred Securities & Income Fund ( PTA ). PTA isn't even the worst performer of the group.

For PTA, we can see a breakdown of their complete holdings list as of the end of December 2022. We should be getting an updated look before too long, but this is what was available at the time of writing. Here's a list and weighting of each position they held at that time.

• SVB Financial Group Flt Perp Sr D 0.42%
• SVB Financial Group Flt Perp Sr C 0.41%
• SVB Financial Group Flt Perp Sr E 0.21%
• Signature Bank New York 5% Perp Sr A 0.20%
• CS Group 7.5% Perp 0.81%
• CS Group 9.750% Flt Perp Sr 144A 0.46%
• CS Group 7.25% Perp 0.34%
• CS Group 6.375% Perp 0.19%

The "Flt" securities here were fixed-to-float. After a certain date, these would become floating-rate securities. It turns out we don't have to worry about that because they won't be making it to their floating rate dates.

As we can see, those were the major hits to the portfolio of around $54.676 million. That comprised around 3.04% of the fund's total market value. That means the hit to NAV was even higher. At the end of 2022 , they had roughly $1.1142 billion in total net assets. That means roughly 4.91% of NAV was hit from these positions alone.

As we know, the losses were much deeper in the last month due to the value of everything else in this space dropping precipitously. Moves like this just aren't something you'd often anticipate in the preferred space.

PTA doesn't specifically tell us exactly what preferred versus CoCo exposure the fund carries. Flaherty & Crumrine funds do break this down in their reports. As an example, Flaherty & Crumrine Dynamic Preferred and Income Fund ( DFP ) listed 19.2% invested as of November 30th, 2022.

So as we were waiting for interest rates to stop rising as rapidly and see yields stabilize, these lower yields came from even worse news. The Fed still raised interest rates another 25 basis points but were seemingly more dovish in tone. They had indicated that they are getting nearer the end of the interest rate hikes as things start to break but aren't ready to give up the fight against inflation just yet.

All this said, there could be some opportunities for investors who are willing to step into this type of volatility. We certainly aren't out of the woods, yet it would seem, but assuming our financial system doesn't collapse and preferreds are still worth something, we could see a recovery over time.

For the most part, we've also seen some CEF discounts open up in the space. That being said, some of the play could be some recovery in the underlying preferreds as things stabilize and not necessarily only looking for discount contraction to take place.

Data as of the 3/27/2023 market close, valuations are changing fast in this volatile space, so always check the latest data.

The Flaherty & Crumrine funds that were often seen trading at premiums quite regularly in years past are some of the most attractive looking at this time. DFP was a name that I picked up recently to dollar-cost average in. Here's a look at the fund's discounts relative to the last 10-year average discount/premiums.

PTA also has managed to see its discount contract during this volatile period relative to its one-year average. However, it still remains at what I would consider an attractive discount.

Perhaps even more peculiar are the John Hancock funds HPF, HPI and HPS. These funds have seen their premiums remain sticky and even rise further.

Of course, it wasn't that these funds weren't impacted in the last month, but that the price drops were more shallow than the NAV drops. The NAV drops in the last month were still steep.

One of the reasons for this is likely due to the fact that the John Hancock funds actually place some emphasis on the "income" part of their names. They are investing a considerable portion of their portfolios in other corporate bond exposure. HPS carried 36% of total investments and 55.4% of their portfolio in more traditional corporate bonds, not CoCos of European banks. Though they also carried some SVB debt, to be sure.

PTA listed 72% of their portfolio as being composed of banking, insurance and finance exposure, with 62% invested in the U.S. HPS listed nearly 85% of their exposure in the U.S., with 51.3% allocated to financials. Utilities were actually the second largest weighting at 27.3% as of their last report. This gives us an idea of why HPS would have performed relatively better.

Conclusion

Preferred closed-end funds have struggled in the last year as interest rates were increasing rapidly and driving up yields. While yields have now dropped, which should have benefited the fund, it was from an even worse event as bank failures sent ripples through the financial industry. Preferred funds have a heavy emphasis on financial preferred as they are a large issuer of preferreds due to helping keep banks within regulatory limits.

Assuming no more large bank failures on our hands and assuming preferreds remain a relevant place to put capital to work going forward, these funds should recover from some of these drops. At the same time, it doesn't necessarily seem like we need to rush in. The dust hasn't necessarily settled yet, and some dollar-cost averaging into some of these funds could be a more appropriate way to approach the situation.

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