Summary
- PFO, along with most preferred and income-focused funds, has faced significant pressure over the last year due to rising interest rates.
- For PFO, being an unhedged leveraged fund meant that the pain came from both sides, rising underlying interest costs and declining underlying portfolio prices.
- That said, the discount has opened up further, and we've already seen glimpses of what can happen when yields start to subside.
Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on February 23rd, 2023.
It seems the pain is never ending for fixed-income and fixed-rate preferred holdings as the Fed continues to combat inflation through higher interest rates. However, we know there will be an end at some point; whether that is a soft landing or hard landing seems to be the biggest debate.
It's been almost a year since we touched on Flaherty & Crumrine Preferred Income Opportunity Fund ( PFO ). The results haven't been too pretty since that time. That being said, the broader equity market, as measured by the S&P 500 Index, also shows results there haven't been pleasant. The S&P 500 Index, of course, isn't an appropriate benchmark, but it can provide us with some context.
PFO Performance Since Prior Update (Seeking Alpha)
Since that time, PFO's discount has also opened up further, and we should be nearer to the end of the rate hikes than the beginning. With some stabilization, the outlook for PFO and its sister funds could be more promising rather than what we've seen in the last year. Bearing in mind, that could include some further distribution cuts as interest rates are still expected to go higher from here - at least a bit higher, with the expected terminal rate around 5.36%.
The pace of the Fed raising rates has been truly aggressive. However, with the more recent 25 bps hike after a 50bps hike, it seems the aggressive pace of 75 bps hikes has at least been halted.
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The Basics
- 1-Year Z-score: -1.20
- Discount: -5.96%
- Distribution Yield: 6.56%
- Expense Ratio: 1.36%
- Leverage: 38.78%
- Managed Assets: $207.842 million
- Structure: Perpetual
PFO's investment objective is "to provide its common shareholders with high current income consistent with preservation of capital." To achieve this, they will invest "under normal market conditions, at least 80% of its managed assets in a portfolio of preferred and other income-producing securities. Preferred and other income-producing securities may include, among other things, traditional preferred stock, trust preferred securities, hybrid securities that have characteristics of both equity and debt securities, contingent capital securities, subordinated debt and senior debt."
That leaves them fairly flexible to invest anywhere in the fixed-income space. They note that "at least 25% of its total assets in companies principally engaged in the financial services sector." That is easy to achieve as the largest issuer of preferred stock is generally from the financial/insurance industry.
The fund's operating expense ratio was 1.36%; however, when including leverage, we see that it climbed to 2.66% at its latest fiscal year-end . They have a fiscal year end of November. That's a rise from the 1.70% at the prior year-end.
This comes down to their leverage, which is a double-edged sword. As rates rise, their borrowings cost more. However, by borrowing, they can still generate higher income. The spread between their borrowing cost and what they earn is becoming quite squeezed.
As we touched on previously, they haven't hedged their portfolio - as none of their funds have - due to that sort of being a double-edged sword too. Hedging can provide some downside protection, but it comes with a cost. Sometimes the cost outweighs the benefit. So you have to take a bet that it'll pay off. Here's what they had to say on that topic during their semi-annual report .
In general, hedging is done for two reasons: first, to reduce absolute exposure to a particular risk; and second, to reduce volatility associated with a particular risk. When considering a hedge against a rise in short-term rates, one must weigh cost versus benefit. If we knew exactly when rates would rise and by how much, then we could evaluate the explicit costs and determine if it would be a winning trade.
Since we don't know the exact timing or magnitude of higher short-term interest rates, a hedge is really another investment decision - one in which we would be betting that the cost of a hedge now (in the form of higher leverage costs today) will be lower than the actual cost of leverage (unhedged) over the hedge's timeframe. In other words, the Fund's distributable income would be lower today if we were to hedge the cost of leverage very far into the future. This is because today's upward-sloping yield curve means the market already expects rates in the future to be higher, so that expected cost is reflected in hedging cost today.
They've kept the same $80.6 million in outstanding borrowings year-over-year. However, the leverage ratio has swelled due to declines in the underlying portfolio.
Performance - Recovery Is Possible; We Saw Glimpses Of It
While waiting for the Fed to be done raising officially is an attractive approach, it can give us some potential upside as timing can be difficult. We can see that even when the Fed is still raising rates, all it takes is the thought that they could be closer to being done for yields to drop substantially. We saw that in the first part of the year with the 10-Year Treasury falling - that propelled funds such as PFO.
However, then we received a hot jobs number and a hot PPI report sending the 10-Year Yield up rapidly once again. That brought a swift turnaround to what was starting to be a recovery for PFO.
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Highlighting the fact that, while waiting is the more conservative approach and can save you from further losses - it can also be an opportunity cost as recovery likely comes before the Fed is really even done.
Historically, the F&C funds were some of the strongest performing. iShares Preferred & Income Securities ( PFF ), a non-leveraged ETF, can provide us with some context.
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Due to the non-hedging this year that we touched on, that certainly hasn't played out in the short term. Still, historically the fund traded at much richer valuations due to its ability to perform well. It's yet to be determined if those days will continue, but I suspect it could happen when interest rates stabilize or even decline at some point again.
Besides the COVID spike lower, the current discount is coming near the bottom of the range of the last ten years.
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Distributions - Leverage Cost Impact
As we touched on above, leverage is a double-edged sword. There is a cost, and that cost is rising, but they can also earn more income for now. F&C funds focus on paying distributions solely from income, so as the costs of their borrowings rise, their net investment income drops. That's why we've seen the last year be a period of rapidly declining distribution for the fund.
During this time, the pace of the hikes being so aggressive translated into the pace of adjustments becoming frequent. Another inverse relationship is similar to what we saw with the actual price of the portfolio above when compared with the 10-Year Treasury Yield.
Subsequently, this is another area that can stabilize if interest rates also stabilize sometime this year. At this point, the leverage cost for PFO is SOFR plus 0.90%. As of writing this, the SOFR rate is currently at 4.55%. Adding the spread on top of that comes to 5.45%. They list that the average coupon of their holdings is 6.64%, meaning that leverage is still beneficial but certainly not incredibly lucrative.
PFO Monthly Data (Flaherty & Crumrine)
A few more rate hikes, and this becomes pressured even further. One way to mitigate this would be if they started transitioning into higher-yielding preferreds - which is certainly possible now as preferreds are cheaper. However, it could become a case where they need to go lower in credit quality.
The fund had historically benefited from its premium in another way, too; they were able to issue shares through their ATM and DRIP. In the beginning part of the 2022 fiscal year, they were able to issue new shares via these means. As we progressed through the year, though, that stopped as the fund went to a discount. In the prior year, we can see that it was beneficial for raising assets. Since it is done at a premium, it is accretive to NAV, which is one benefit of when a fund trades at a premium.
To help smooth out the impact of more shares on the NII income on an absolute basis, we can also look at the per-share NII. In the latest fiscal year, it came to $0.75, down from $0.81. Of course, that's the interest rate expenses hitting the fund. The interest expenses went from $713.8k to $1.778 million.
The actual total investment income for the fund went from $13.083 million to $13.384 million. This can come from portfolio changes and from some of the floating rate and fixed-to-float exposure that they carry. If it hadn't been for that, the declines would have been a bit larger.
One of the big benefits of holding preferreds and PFO is that the majority of their distributions are considered qualified. In 2021 , 83.6% were considered qualified. At this time, they don't have the 2022 information available, but this is generally the trend, with a significant portion qualified.
PFO's Portfolio
This is the non-eventful portion of my updates on PFO - or even any of the F&C funds, really. They have a very limited turnover, with PFO coming in at 8% last year. That was actually slower than the preceding four years they list in their financial highlights section. This tells us they aren't buying and selling positions aggressively. They seem to buy a position and simply hang on to it.
With a large portion of their portfolio tied to financial-related issuing companies, these are often perpetual preferreds they allocate their portfolio. That means that they can end up holding onto these positions indefinitely potentially.
They also don't focus solely on below-investment-grade credit quality either, as their portfolio has some balance, with BBB rated debt being the largest category. Investment grade debt can be more interest rate sensitive as yields are lower. This can help explain the effective duration of PFO's portfolio being 5.5 years, whereas an all-junk portfolio would naturally be lower. Some of this duration would be offset to the floating rate exposure.
Where credit quality can come to the rescue could potentially be later this year. With an anticipated recession, defaults and bankruptcy can become a hit to a lower-quality portfolio. The chances of large swaths of their portfolio defaulting or becoming a significant drag on the portfolio are minimized.
To help highlight how low turnover the portfolio has, we can see the top 25 issuers. Remember, the last time we looked at the fund was nearly a year ago. Yet, we see many of the same names listed today.
MetLife ( MET ), Morgan Stanley ( MS ), Energy Transfer ( ET ), Wells Fargo ( WFC ) and Liberty Mutual Group were all top five positions at the end of February 2022, in slightly different weightings. Bearing in mind these are preferred holdings the fund carries and not the equity positions.
Here's a look at the MET exposure; it comes from three different positions. As most readers will probably know, the 144A designation means these are not registered securities and instead are sold to qualified institutional buyers. Most retail investors wouldn't typically have access to these types of securities except through professionally managed funds.
Conclusion
PFO has had a rough year, though it isn't alone in the preferred and fixed-income space. Interest rates have wreaked havoc on their underlying portfolio and meant rising interest rate costs. The premium going to a discount on the fund has also exaggerated those downside moves. However, we are now at a time when we can consider going more aggressive in these names if the Fed is close to its terminal rate. We already saw glimpses of a sharp recovery as soon as yields started to drop. Of course, those more patient and conservative may wait longer on the sidelines. That certainly isn't a bad strategy, but it can mean giving up some of the potential recovery, as we saw, and can be quite sharp when it happens.
For further details see:
PFO: Preferred And Income Pain Continues, But Valuations Getting Tempting