2023-12-12 00:31:07 ET
Summary
- Preferred shares should benefit from the end of the Fed rate hiking cycle.
- The Virtus InfraCap U.S. Preferred Stock ETF near 10% distribution is well covered.
- The portfolio may produce an 18% total return if UST yields decline to 3%.
Summary
Preferred shares are difficult to analyze, and value given their quasi-debt and equity characteristics. When risk-free rates are low the instruments provide higher yields than bonds with lower volatility than the common shares of the same company. When rates rise the prices fall more than bonds given their equity traits i.e. companies do not need to pay the dividends nor the principal. At the current juncture in the US rate cycle, it appears preferred shares may offer higher risk-adjusted gains than corporate bonds. The Virtus InfraCap U.S. Preferred Stock ETF ( PFFA ) does not have a great track record due to the very negative market environment for preferred shares in the last 5yrs. However, the current portfolio looks to have above-average return potential heading into a long-term rate decline cycle.
Performance
As may be expected PFFA has underperformed the broader market, US Treasuries, and corporate bonds during the Fed rate hike cycle. It has performed in line with the SP US Preferred index and when adjusted for dividends it has gained nearly 30% since 2019. In my view, investors should compare funds and or stocks vs peers and alternatives to guarantee that specific funds' alpha capacity and asset class can beat the broader market on a risk-adjusted basis.
PFFA vs Bonds (Created by author with data from Capital IQ) PFFA vs Index (Created by author with data from Capital IQ)
Preferred Shares Nuances
The securities are generally issued by a company to reduce leverage i.e. instead of taking on an obligation to pay back a set amount at a future maturity day plus interest, a company issues preferred shares with high and established dividend payments. The advantage to the company is that they may never need to pay back or call the preferred shares.
Most preferred are issued at US$25 or par with a set coupon yield. Some have call options, floating rates, convertible to common stock, may accumulate dividends due, etc. Each has a different characteristic that can be beneficial or negative depending on the rate cycle and the company's financial health. A preferred share can lose all of its value if the company cannot pay dividends, enters into default, etc.
MDP and Leverage
PFFA has managed a distribution program where it pays out about US$2 a share split evenly over 12 months. The bulk of the distribution comes from dividends received from its portfolio and supplemented by capital gains or a return of capital. They also add leverage, up to 30% of AUM, to augment returns and take advantage of market dynamics. These two items, MDP and leverage, increase the risk of the overall portfolio in my view.
PFFA Distribution (Seeking Alpha)
Portfolio Overview
I calculated the portfolio's current dividend yield at 8.6% vs the coupon of 7.1%. The shares are all trading at a discount to par, some are in distress. This portfolio is concentrated in electric utilities, gas distribution, REITS, and Insurance companies. The typical company that requires a higher degree of leverage and issues preferred to keep debt lower. I assume the manager is aware and expects turnarounds or sees mispricing at the stocks that are substantially below par. If the portfolio were traded at Par this would result in a 22% price gain.
PFFA Portfolio Yield (Created by author with data from Capital IQ)
Rate Sensitivity
Preferred stocks are mostly valued as bonds and fluctuate with rates and capacity to continue paying their stated dividend yield i.e. credit quality. I conducted two rate sensitivity analyses to gauge the impact on prices if risk-free rates or the 10-year treasury declined. The first step is to measure the risk premium or the spread over treasury that the market requires for each preferred. This risk premium is a combination of market perception and company fundamentals, a wide rate spread indicates higher risk. The current portfolio has a 460-basis point risk premium that is likely to be maintained in the short term.
PFFA Portfolio Risk Premium (Created by author with data from Capital IQ)
Price Upside with 10yr UST at 3%
Assuming the Fed cuts rates from 5% to 4% and the 10-year US Treasury yield declines to 3% from 4.2% today I calculate the current portfolio has an 8.3% upside. This assumes that the risk premium is maintained at 4.6%. Given that this is an actively managed fund the portfolio may react more positively if management insight into some default-priced stocks improves.
PFFA Upside at 3% UST (Created by author with data from Capital IQ)
PAR Reached with 10yr UST at 2.6%
For the portfolio to reach Par I calculate that the 10-year treasury would need to decline to 2.6%, which may be equivalent to a 3% fed funds level. This assumed no risk premium changes for the underlying companies. Under this scenario, the fund could have a 22% upside potential. This is perhaps not a 2024 outlook, but the upside does exist as long as the US inflation situation continues to converge to the Fed's 2% target.
PPFA upside at 2.6% UST (Created by author with data from Capital IQ)
Conclusion
I rate the PFFA a BUY. The fund has good coverage i.e. dividend yield to distribution rate, which provides a 10% monthly payout. As the Fed cuts rates the value of the Preferred shares should increase and generate a total return of 18% under my estimates.
For further details see:
PFFA: Inflection Point