2023-06-27 19:24:56 ET
Summary
- Investors are in desperate need of additional sources of income to maintain their standard of living in the face of the highest inflation that we have seen in years.
- Flaherty & Crumrine Dynamic Preferred and Income Fund invests in a portfolio consisting of preferred stock and bonds with the goal of providing investors with substantial distribution income.
- The DFP closed-end fund is heavily weighted to the banking sector, but it is not bad compared to preferred stock indices.
- The fund can probably sustain its distributions, as it is only paying out Net Interest Income, or NII, plus a portion of its net realized gains.
- The fund is trading at a discount to net asset value at the current price.
There can be little doubt that one of the biggest problems facing the average American today is the incredibly high level of inflation that is plaguing the economy. This is evidenced by the consumer price index, which claims to measure the value of a basket of goods and services that is regularly purchased by the average consumer. As we can see here, the consumer price index's year-over-year increase has exceeded the 2% level that is considered healthy during each of the past twelve months:
As I have noted in a few previous reports (see here ), the reported consumer price index is being driven lower by the simple fact that energy prices are down versus the year-ago period. When we exclude volatile food and energy prices (the core consumer price index), we see that inflation has not come down nearly as much as the headline numbers indicate. Regardless, the prices of many goods and services are significantly higher than they were during the same period last year and this has strained the budgets of numerous American households. Indeed, there has been a surge in the number of people seeking out second jobs or entering the gig economy just to maintain their standard of living, which may be one reason why the jobs numbers remain robust despite every other indicator pointing to an imminent recession.
As investors, we are certainly not immune to the ravages of inflation. After all, we need money to pay our bills, gas up our cars and generally enjoy life. All of these things cost more money than they did only a year or so ago. Thus, we also need extra money to maintain our lifestyles. Fortunately, we do not necessarily need to take on a second job to obtain it. This is because we have the ability to put our money to work for us earning an income. 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 unfortunately not very well-followed in the financial media and many investment planners are unfamiliar with this. This is a shame because it makes it difficult to obtain the information that we would like to have in order to make an investment decision. These funds possess some advantages over exchange-traded or open-ended funds, such as the ability to employ certain strategies that boost their yields well beyond that of the underlying assets. That is obviously going to be appealing for anyone that is seeking income.
In this article, we will discuss the Flaherty & Crumrine Dynamic Preferred and Income Fund ( DFP ), which is one CEF that falls into this category. As of the time of writing, this fund yields an impressive 7.49% as of the time of writing. This is certainly enough to appeal to anyone that is seeking an income. I have discussed this fund before, but a few months have passed since then and naturally several things have changed. This article will focus specifically on those changes and provide an updated analysis of the fund's financial condition.
About The Fund
According to the fund's webpage , the Flaherty & Crumrine Dynamic Preferred and Income Fund has the stated objective of providing its objective with a high level of total return. This is a bit surprising considering that its name suggests that it invests in preferred stock and debt securities. Indeed, as we can see here, the majority of the fund's holdings are in preferred stocks, although it does have a significant allocation to bonds:
CEF Connect
This is why the focus on total return is a bit surprising. Fixed-income investments such as preferred stock and bonds deliver nearly all of their returns via direct payments made to the investors. In fact, in the case of a bond, an investor that purchases the bond at issuance and holds it to maturity will receive no capital gains at all. This is because the bond is purchased at face value and repays its face value at maturity. The same is generally true of preferred stock, but a preferred stock has no maturity date. It might have a date at which the company can force the investors to sell it back to the company though, which is typically done at the issuance price. Thus, fixed-income securities are not total return vehicles, they are income investments.
With that said, it is possible for fixed-income investors like this fund to earn capital gains due to the fact that fixed-income prices fluctuate with interest rates. It is an inverse relationship, so when interest rates go up, bond prices go down and vice versa. As everyone reading this is certainly well aware, the Federal Reserve has been very aggressively hiking interest rates in the United States over the past fifteen months. We can see this here:
As of the time of writing, the effective federal funds rate is 5.06% compared to just 0.08% in February of 2022. This was one of the fastest periods of interest rate hikes in history and it has also driven rates to the highest levels that we have seen in the country since 2007. It has naturally driven down the price of both preferred stocks and bonds. We can see this in the fact that the iShares Preferred and Income Securities ETF ( PFF ) is down 6.53% over the past year:
The Flaherty & Crumrine Dynamic Preferred and Income Fund was not spared this carnage, either, as it has declined a whopping 16.54% over the same period:
With that said, though, the fund's actual portfolio did not perform nearly as badly as the price action would indicate. This is a characteristic of closed-end funds that differentiates them from exchange-traded funds. As a closed-end fund is not continually issuing new shares, its share price in the market can sometimes perform very differently than the underlying portfolio. Over the past year, this was especially noticeable as many securities that were popular among income seekers during the 2021 bubble in everything were sold off once interest rates started rising. This chart shows the total returns of the fund and the fund's portfolio through May of 2023:
As we can see, the portfolio delivered a -9.8% return over the trailing one-year period. That is much better than the fund's market price performance, although it is still somewhat worse than the preferred stock and income securities index that we just mentioned. This performance differential between the fund's share price and its portfolio has created an interesting opportunity, which we will discuss in a bit.
In my last article on the fund, I noted that it is very heavily invested in bank securities. This is still the case, as we can see here:
Flaherty & Crumrine
As we can see, fully 58.3% of the fund's portfolio is invested in bank securities. This is a decline from the 59.8% weighting that the fund had to the banking sector the last time that we looked at it, but it is still high enough to cause some concern for those worried about the banking sector in the aftermath of a few high-profile bank collapses. However, it is common for a preferred stock fund to have a very high allocation to bank securities because banks are by far the largest issuers of preferred stock in the market. This is due to international banking regulations that require a bank to maintain a certain percentage of Tier One capital. Tier One capital refers to the assets of the bank that are not simultaneously a liability to someone else (such as a depositor). In effect, this is the bank's "own money."
When regulators require that a bank increase its Tier One capital, the bank basically has the option of issuing either common or preferred stock. In many cases, it will opt to issue preferred stock to avoid diluting the shareholders. There are no other sectors that have regulatory requirements such as these so most companies in other industries will opt to issue debt when they need to raise capital. This is because debt is much cheaper than preferred stock. Thus, by default, the majority of preferred issuances in the market are performed by the banking sector. The iShares Preferred and Income Securities ETF is 69.70% weighted to financial institutions, so we can see that the Flaherty & Crumrine Dynamic Preferred and Income Fund does not appear to be excessively weighted to the sector. That should prove to be some comfort for those worried about the banking sector.
In previous articles on other closed-end funds, I noted that many fixed-income funds tend to engage in very limited trading activity. In fact, it seems fairly common for these funds to employ a buy-and-hold strategy. The Flaherty & Crumrine Dynamic Preferred and Income Fund is certainly not an exception to this as it had an annual turnover of just 7.00% for the full-year period that ended on November 30, 2022. That is exceptionally low for a closed-end fund, but it is something that is fairly nice to see. This is because it costs money to trade stocks and other assets and these costs are billed directly to the shareholders. That creates a drag on the fund's performance and makes management's job more difficult.
After all, the fund's management needs to earn sufficient returns to cover these extra costs and still have enough left over to satisfy the shareholders. This is a very difficult task that very few management teams manage to accomplish on a regular basis, which is one reason why many closed-end funds fail to beat their benchmark indices. As we have already seen, this fund did fail to beat the preferred stock and income securities index over the past year but that is not a perfect comparison because the Flaherty & Crumrine fund includes traditional bonds that would alter its performance versus the index.
Leverage
In the introduction to this article, I mentioned that closed-end funds have the ability to employ certain strategies that boost their effective yields beyond that of the underlying assets in the portfolio. One of these strategies is the use of leverage. In short, the fund borrows money and then uses that borrowed money to purchase preferred stock and other income-producing assets. As long as the yield of the purchased assets is higher 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 money at institutional rates, which are considerably lower than retail rates. As such, this will normally be the case. With that said, this strategy was more effective at juicing returns prior to the recent interest rate hikes.
The use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not using too much leverage because that would expose us to excessive levels of risk. I generally do not like to see a fund's leverage exceed a third as a percentage of its assets for this reason. Unfortunately, this fund is substantially above that level as its levered assets currently comprise 41.29% of the portfolio. When we consider this, it is actually pretty surprising that this fund's portfolio performance has not been more volatile than what we have seen over the past year.
The fund's assets are reasonably safe, but it does mean that any further rate hikes will probably result in this fund taking larger losses than a comparable fund with lower levels of leverage. The Federal Reserve is currently predicting that it will impose two more rate hikes this year so this is something that we should keep in mind.
Distribution Analysis
As stated earlier in this article, the primary investment objective of the Flaherty & Crumrine Dynamic Preferred and Income Fund is to provide its investors with a high level of total return. However, the fund has specifically stated that it will be delivering the majority of its returns in the form of direct payments to investors. In order to achieve this objective, the fund invests in a portfolio of preferred stocks and bonds that tend to have fairly high yields. It then applies a layer of leverage to boost the yield beyond that of the underlying assets.
As such, we can probably assume that this fund will have a very high yield. This is certainly the case, as the fund pays out a monthly distribution of $0.11 per share ($1.32 per share annually), which gives it a 7.49% yield at the current price. Unfortunately, the fund's distribution has varied quite a bit over the years:
This is hardly surprising, as most closed-end funds that invest in fixed-income securities have had to vary their distributions quite a bit over the years. After all, interest rates have a very significant impact on the investment profits that these funds are able to earn and thus are able to pay out. The variable distribution is still likely to be a negative factor for those investors that are seeking a safe and secure source of income to use to pay their bills, however.
With that said, anyone purchasing the fund today will receive the current distribution at the current yield. As such, the fund's past is not exactly the most important thing. A new investor is going to be more concerned with how well the fund can maintain its current distribution. So, let us investigate this.
Unfortunately, we do not have an especially recent document that we can discuss for this purpose. The fund's most recent financial report corresponds to the full-year period that ended on November 30, 2022. As such, it will not include any information about the fund's performance over the past seven months. This is disappointing, but the bulk of the carnage in the fixed-income market took place in 2022 due to the Federal Reserve adopting a monetary tightening regime so at least we can still get a pretty good idea of how well the fund handled that. During the full-year period, the fund received $17,674,452 in dividends and $27,861,907 in interest from the assets in its portfolio. When we combine this with a small amount of income from other sources, the fund had a total investment income of $45,644,183 over the period. It paid its expenses out of this amount, which left it with $34,341,066 available for shareholders.
This was not quite enough to cover the $35,572,920 that the fund actually paid out, but it did get very close. In the full-year period that ended on November 30, 2021, the fund had a net investment income of $36,039,941 and paid out $38,223,563 in distributions. Thus, it appears that this fund is paying out its net investment income plus a bit extra during most years.
This extra amount that the fund is paying out looks to be covered by net realized gains. During the full-year period that ended on November 30, 2022, the fund reported net realized gains of $6,573,639, which is more than enough to cover the fund's distribution combined with net investment income. The same was the case during the prior-year period. The fund's annual report states that the distributions are being financed entirely out of distributable earnings, but net investment income alone is not enough to cover them as shown here:
Regardless, it does appear that the fund is pulling in enough cash from its operations to cover the distributions. The real concern is the $127,400,007 net unrealized losses. This more than offset all of the fund's net investment income and net realized gains. Overall, the fund's assets went down by $111,222,581 during the most recent full-year period. This is almost certainly the reason for the distribution cuts as a smaller asset base makes it more difficult for the fund to earn the returns that it needs to maintain the distribution. Overall, though, this fund does appear to be a lot more conservative than many of its peers, as its distribution is mostly financed by net investment income. Thus, it probably can maintain its distribution, although we might see another cut or two later this year if the Federal Reserve hikes rates again and causes the fund to suffer more losses.
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 surefire way to earn a suboptimal return on that asset. In the case of a closed-end 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. This is, therefore, the amount that the shareholders would receive if the fund were immediately shut down and liquidated.
Ideally, we want to purchase shares of a 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 purchasing the fund's assets for less than they are actually worth. I mentioned that this is sometimes a possibility earlier in this article.
This does, fortunately, apply to this fund today. As of June 26, 2023 (the most recent date for which data is available as of the time of writing), the Flaherty & Crumrine Dynamic Preferred and Income Fund had a net asset value of $19.13 per share but the shares currently trade for $17.53 each. This gives the shares a discount of 8.36% to the net asset value at the current price. That is relatively in line with the 8.60% discount that the shares have averaged over the past month. Thus, the price for Flaherty & Crumrine Dynamic Preferred and Income Fund seems reasonable today.
Conclusion
In conclusion, investors are desperately in need of additional sources of income to maintain their standard of living in today's inflationary environment. The Flaherty & Crumrine Dynamic Preferred and Income Fund appears to be one way to get that income, and it is a very good one. The fund has generally performed reasonably well, although its market performance over the past year leaves a lot to be desired. The fact that the fund's portfolio has outperformed its market price, though, has provided an opportunity for investors today to get the shares for less than their intrinsic value. When we combine this with an apparently sustainable 7.49% yield for Flaherty & Crumrine Dynamic Preferred and Income Fund, we have the makings of a good addition to an income portfolio.
For further details see:
DFP: This Excellent Income CEF Is Selling At A Discount