2023-09-15 04:14:35 ET
Summary
- The AAM Low Duration Preferred & Income Securities ETF is a fixed income fund.
- The fund's collateral is composed of preferred securities, mainly from the banking and financial services sectors.
- The fund's short duration profile helps to reduce interest rate risk, and its focus on investment grade securities and systemically important financial institutions mitigates default risk.
- The vehicle has a low portfolio duration of 1.45 years, and a 3-year standard deviation of 8.3.
- Contingent capital securities ('cocos') are not eligible to be included in the collateral pool.
Thesis
The AAM Low Duration Preferred & Income Securities ETF ( PFLD ) is a fixed income exchange traded fund. The vehicle aims to provide a high monthly dividend via a portfolio of duration managed preferred securities. PFLD offers a 6.68% 30-day SEC yield with a 1.45 years portfolio duration:
30-day SEC yield (Fund Website)
The fund aims to replicate the total return performance of the ICE 0-5 Year Duration Exchange-Listed Preferred & Hybrid Securities Index through its composition. The particularities of this index lie in the constraints on the collateral pool:
- underlying securities must have an option-adjusted duration of less than 5 years
- the securities must be listed on an exchange
- the upper bound of the price for the included securities is 105%
Furthermore, contingent capital securities ('cocos') are excluded for the purpose of the index and PFLD. The fund contains almost 50% of bank and financial services preferred securities, thus the exclusion of a highly volatile asset class such as contingent capital securities is a positive. As a reminder, 'cocos' are issued by banks, and in certain capital impairment instances they can get converted to regular equity, thus being relegated to a lower rung of the capital structure. Point in case, when Credit Suisse was taken over by UBS, their entire suite of 'cocos' got wiped-out , with investors now looking to sue.
Although we are nearing the end of the current monetary tightening cycle, the fund's low duration has helped it navigate 2023 quite well, with a very shallow -7% drawdown, almost entirely driven by credit spread widening during the March regional banking crisis.
This vehicle is similar to a large degree to the much better known iShares Preferred & Income Securities ETF ( PFF ) which we covered here with a Buy rating right after the regional banking crisis. The article compares the performance of the two funds, with the result being a very close correlation and an outperformance by PFLD.
Analytics
- AUM: $0.2 billion.
- Sharpe Ratio: -0.13 (3Y).
- Std. Deviation: 8.33 (3Y).
- Yield: 6.68% (30-day SEC yield).
- Premium/Discount to NAV: N/A.
- Z-Stat: N/A.
- Leverage Ratio: 0%.
- Composition: Fixed Income - Preferred Securities
- Duration: 1.45 yrs.
- Expense Ratio: 0.45%.
Holdings
The fund holds a portfolio of 188 names, mainly coming from very large capitalization companies:
Details (Fund Website)
This exchange traded fund holds significant risk to banking and financial services institutions:
Sectors (Fund Fact Sheet)
We can see that the banking and financial services sectors account for almost 50% of the fund holdings, followed by insurance and real estate. This is a common feature in many preferred shares exchange traded funds, where the collateral is mainly sources from the top industries we see in this fund. There are regulatory and structural features that help issuances from these sectors.
The banking sector for example is highly regulated, with strict leverage ratio and capital requirements. Preferred shares do not count as debt and for certain series interest payments can be skipped in certain circumstances for the underlying issuer.
Although the fund has a high concentration to the financial services sector, the top names in the fund are all systemically important financial institutions:
Top Holdings (Fund Fact Sheet)
While we saw credit spreads widen for the above names during the regional banking crisis , none of them where ever thought to be in danger of not performing. In fact, the FDIC reached out to the larger institutions in order to rescue some of the smaller lenders, with JPMorgan actually taking over First Republic. In terms of financials preferred shares, this is where you want to be - systemically important large institutions that are too big to fail.
Given that rates have continued to move higher since March, it is possible that we will see another flare-up in terms of regional banks, although the possibility is remote, and the regulators have set-up dedicated facilities to deal with bank funding stress, such as the Bank Term Funding Program.
Performance and Drawdowns
The fund is marginally up this year on a price basis, outperforming PFF:
We can see the two names being very closely correlated up to July, when PFLD started outperforming. Moreover, it is interesting to notice that even during a very rough 2023, the fund had only a -7% drawdown profile from a price perspective. If we plot the fund's total return, the results look even better:
In today's environment an investor should be very concerned with drawdowns, and a fund that has a high yield but a shallow drawdown is very much preferrable over other alternatives.
What is the primary risk associated with this fund? Credit spreads is the answer.
Firstly the interest rate risk associated with the name is low due to the short duration profile for the fund and the end of the monetary tightening cycle. We can strike this one out for now.
Secondly, we believe the default risk associated with the names in the collateral pool is low. The fund has a very robust build, choosing companies with very large capitalizations. Furthermore the collateral pool is granular, with the vast majority of the names sub 1.5% of the fund, while volatile 'cocos' are entirely excluded. From a ratings standpoint a very large portion of the collateral pool is investment grade:
Ratings Matrix (Fund Fact Sheet)
Thirdly, the only pertinent risk here is that of credit spread widening. If we do have a recession and the market sells-off, we are going to see credit spreads widen. This will result in a lower value for the securities and the fund implicitly. Taking March 2023 as a blueprint gives us a -7% expected drawdown here. For a fund yielding 6.6%, having such a shallow drawdown yields a good risk/reward ratio. The drawdown is almost entirely covered by the fund's carry here. An investor in today's environment chasing yield should carefully analyze the drawdown profile of a potential investment.
Conclusion
PFLD is a fixed income exchange traded fund. The vehicle holds short duration preferred securities, mainly from the banking and financial services sectors. Through its construction, the fund does not invest in contingent capital securities, and its largest holdings are systemically important financial institutions.
The vehicle has a robust granular build, with a 6.68% 30-day SEC yield and a 8.33 standard deviation. Its risk/reward metrics are favorable, the fund having a very low duration. This ETF is very similar to PFF which we covered before. PFLD however has a shorter duration and has outperformed in 2023. The main risk factor for this name is constituted by credit spread widening. A risk off event can be modelled as creating another -7% to -9% drawdown for the fund, with the vehicle covering most of that through its carry. Given the higher cyclical interest rate environment, financial services preferred securities are trading at multi year lows, creating an opportune entry point for a high yielding asset class. We feel this fund does a good job of mitigating default and credit spread risk, therefore we are a Buy for the name here, with a 24 months minimum holding horizon.
For further details see:
PFLD: Low Duration Preferred Securities Fund With An Appealing Yield