WFC - SPFF: The Blind Yield Chase Performs As Expected

2023-09-18 16:05:27 ET

Summary

• SPFF, a high-yield preferred share ETF, has underperformed and carries significant risk due to its focus on highest yields.
• The fund primarily holds preferred shares in the financial sector, which can be risky during a severe recession.
• The current yield of SPFF has been reduced due to capital destruction, making it less attractive compared to other options.

Risk comes in all shapes and sizes, and sometimes even the most benign looking funds can hold a lot of risk. We have previously covered Global X SuperIncome™ Preferred ETF ( SPFF ) and it was very hard to find absolutely anything to like about it. While a lot of funds chased yield and most got the lumps handed to them, SPFF was setup at the bottom of even that chain. Our warnings words last time were as follows.

SPFF has underperformed a garden variety preferred share ETF and that was to be expected. The current conditions are far more dangerous as we highlighted recently, and investors should not be throwing caution to the wind. Index following ETFs are now getting loaded up with higher and higher risk securities and we don't see that having a happy ending. On preferred shares, you have to pick your spot and if you don't want to do that, prepare for some brutal lessons in where yield chasing gets you.

Source: A Great Time To Sell

That was not what the bulls wanted to hear, but SPFF has indeed given them a very poor ride so far.

We look at what the fund is holding today and update our thesis.

The Strategy

The fund's mandate has not changed, and it continues to aim for the biggest yields.

SPFF invests in 50 of the highest yielding preferreds in the United States, potentially increasing a portfolio's yield.

Source: SPFF Website

Yes, there is no mention of capital preservation or of total returns. We are just going by highest yields. The fund is following the Global X U.S. High Yield Preferred Index, which does keep it away from some of the truly CCC rated kind of preferred shares. The holdings today are primarily focused in the financial sector, with Wells Fargo ( WFC ), Bank of America ( BAC ), JPMorgan ( JPM ) and Capital One Financial Corporation ( COF ) gracing the top 5.

Even further down, outside the odd telecommunication pick like AT&T ( T ) or Energy Transfer LP ( ET ), it is a boatload of financials that you are investing in. To some extent, this is what you would expect from most preferred funds, as financial sector issues more preferreds than any other. That permanent source of capital is a big part of the structure. Most, or should we say almost all, of the preferreds from financials are also non-cumulative. So you can really get a big double whammy in a severe recession, where preferred shares may not even outperform common shares. SPFF is not really unique in laying the bet on financials. iShares Preferred and Income Securities ETF ( PFF ) sector holdings are in the same ballpark.

So we don't want to give it extra grief for holding financials as the primary bet, but we want to emphasize that its "yield seeking" strategy gets extra dangerous in this arena. If you are buying the highest yielders with zero regard to underlying fundamentals, you will pick up some preferred shares just as they are about to cut. Then you will go dump those same preferred shares. In case that seems like something we are saying just to give the fund grief, here is some proof.

First Republic Bank ( FRCB )

The first half of this year was characterized by some intense volatility in regional banks, and guess which preferred shares landed on the SPFF roster.

They were held on April 30, 2023. This was 3 weeks after preferred dividends were suspended and 3 days after rumors were swirling of a complete wipe out for common shares as FDIC prepared to take over the bank . We are not faulting anyone from making a calculated long bet on the bank. Certainly, there were pros and cons to that. But no one could realistically evaluate the positive aspects of that bet by saying, "Hey, let's buy First Republic Bank preferred shares, they have the highest yield." It just makes sense that if you want to generate alpha in a sector that is notorious for blow-ups, you want to extend your screening beyond yields.

Outlook And Verdict

Regional bank stress is getting higher. There are two key sources here. The first being that the banks have a far greater exposure to commercial real estate and far greater exposure to office loans.

The second issue is that the yield curve is deeply inverted, and deposit outflow will accelerate over time. At this point, banks would usually be paying hefty rates to stem the outflow, but they still seem to be comatose from ZIRP (zero interest rate policy).

In this climate, we would not want to own PFF. We would want to own preferred share closed end funds like ( JPS ) and ( FLC ) even less. There you have leverage adding to woes of the dangers that already exist. PFF does not use leverage, but its chase of the highest yields is about as dangerous as adding leverage. We can see this in the performance of SPFF versus PFF.

Twice the price loss and half the total return. So the proof is in the pudding. Don't go chasing yields blindly. There are many quality bonds and preferreds yielding over 7% today. See here and here for examples. These handily exceed the yield you are getting on SPFF.

Even more importantly, SPFF's yield has been reducing on your original cost, thanks to a vast amount of capital destruction. So the current yield is only about 4% on the IPO price of $15.00 per share. We reiterate our Sell rating here.

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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