2023-07-17 01:51:30 ET
Summary
- Cohen & Steers Tax-adv Prd Sec and Inc is recovering from the banking crisis and offers the potential for decent performance due to its valuation.
- The fund has hedged against rising rates using interest rate swaps. The fund's recovery has been aided by the stabilization of banks and a slower pace of interest rate increases.
- Investing in PTA is a bet on no more large regional bank failures and a belief that interest rates will not rise significantly beyond the two anticipated hikes.
Cohen & Steers Tax-adv Prd Sec and Inc ( PTA ) remains at an attractive discount, though it has narrowed a touch since our prior update . The fund is making some recovery from the banking crisis when many preferred funds experienced precipitous drops. This fund wasn't alone, and it has been quite a struggle for going on over a year now. The valuation and the potential for decent performance going forward are what make it appealing.
We've discussed this in more detail previously, but the preferred and income funds were struggling with higher interest rates when the banking crisis hit them. This saw a rapid plunge across the board as preferred closed-end funds are generally overwhelmingly invested in the financial sector offerings. Several funds, including PTA, would have seen holdings wiped to zero with the bank failures.
It appears, for now, banks overall have stabilized. The slower pace of interest rate increases, and with only a couple more anticipated, should also bode well going forward. A combination of these factors has helped the fund start to recover since our prior update.
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The Basics
- 1-Year Z-score: 0.54
- Discount: -8.98%
- Distribution Yield: 9.23%
- Expense Ratio: 1.73%
- Leverage: 36.59%
- Managed Assets: $1.64 billion
- Structure: Term (anticipated liquidation date is October 27th, 2032)
PTA's investment objective is quite simple, "high current income." They also have a secondary objective that is similarly simple, "capital appreciation."
To achieve this, they will invest "at least 80% of its managed assets in a portfolio of preferred and other income securities issued by U.S. and non-U.S. companies, which may be either exchange-traded or available over-the-counter." They also will "seek to achieve favorable after-tax returns for its shareholders by seeking to minimize the U.S. federal income tax consequences on income generated by the Fund."
Just as higher interest rates have impacted PTA's underlying portfolio, the leverage PTA utilizes is also being impacted. However, in the case of PTA, the fund is mostly hedged against the rising rates for the next few years. This is because they've utilized interest rate swaps. This gives them some breathing room in terms of having to feel the higher borrowing costs. Rates are expected to be lower next year and the year after, meaning they could get better rates when some of these swaps mature.
PTA Leverage Facts (Cohen & Steers)
With the banking fiasco earlier in the year, it did put PTA in a position where they also had to deleverage. That's why when we last covered the fund, they had 85% listed as being fixed rate, and this has now climbed to 97%.
Performance - Discount Narrows But Still Has Appeal
One thing that investors should probably be aware of is that most preferred CEFs don't invest in just preferred and corporate bonds. They also mix in contingent convertible securities or CoCos. Besides the banks being wiped out in the U.S., Credit Suisse saw their CoCos wiped out as well - and when that happened, valuations across the board in these types of securities were impacted. Cohen & Steers noted this divergence in their last semi-annual report. The semi-annual report is the six months that ended April 30th, 2023.
A meaningful performance divergence occurred within the preferreds market: U.S. investment-grade preferreds generated a healthy 6.6% total return, while contingent capital securities (CoCos, issued primarily by European banks) returned -4.2%. Preferred securities overall rose but underperformed longer-term U.S. Treasuries, investment-grade corporates and high-yield bonds.
They are holding out some hope of recovery from the CS CoCos. This would be a positive for the fund, but I wouldn't count on it being a meaningful driver of recovery going forward for the fund.
In Europe, struggling Credit Suisse was acquired by rival UBS in March. In brokering the deal, the Swiss government took the unusual step of completely writing down the nominal value ($17 billion) of all Credit Suisse Additional Tier 1 (AT1) bonds, also known as CoCos, which added to pressures in the preferred securities market. (Subsequently, with the AT1 bonds written down before the common equity, lawsuits have been filed, and a secondary market for ownership claims has arisen, which may allow for a partial recovery of the preferreds' value.)
One thing that might be interesting to note in the period that is being reflected is that the fund did actually experience essentially flat total return performance despite the plunge. This is because the period just happens to also reflect bouncing off the lows that we saw in October in equities and fixed-income securities.
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When this occurred, though, the fund was deleveraged, as we mentioned above. That means that going forward, we shouldn't anticipate that PTA can ever make a full recovery to pre-2022 levels. There could be some recovery, and total returns could still be positive, which reflects distributions received, but when a CEF deleverages, that's a huge hurdle to try to climb back up due to the reduction in assets to recover with. The chart below only shows the price and NAV changes for the fund since inception, not including the distributions that the total return would reflect.
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It isn't impossible, but it would generally require a lower distribution rate that is being covered and/or a meaningful recovery in the preferred space. When rates are cut, they could certainly get a boost from that, but we also are anticipating a couple more hikes, too.
PTA isn't alone in what it has experienced either, as peers have shared similar fates. Flaherty & Curmrine Preferred and Income Securities Fund ( FFC ), John Hancock Preferred Income Fund ( HPI ) and Nuveen Preferred & Income Opportunities Fund ( JPC ) have all shown similar results in the last year.
I've also included the iShares Preferred & Income Securities ETF ( PFF ) for some added context as well. Aside from being non-leveraged and passively managed, the fund is also a pretty straightforward preferred fund that doesn't include some of the hybrid and derivate types of investments you'll see in CEFs.
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During this time, PTA has been the top performer when compared to these similar peers. It was even competitive against PFF, which is a bit surprising given the fund's leverage. For FFC, the total share price return was hindered significantly by the fund shifting from a premium to now trading at a discount.
HPI is also a bit different from the CEF funds as they don't mention anything with CoCo securities, which would suggest they don't hold any. That didn't seem to help the fund's performance either way.
Additionally, JPC is looking to acquire its sister funds as they are currently going through a merger proposal. These funds overlap enough that they shouldn't change materially going forward; it would simply just be a larger fund.
The discount has narrowed some for PTA, but it remains attractive for longer-term investors that find appeal in the preferred space. The current discounts also seem to be within the range that is starting to develop for PTA, between a 5% and 14% discount.
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Distribution - Attractive Rate, But Watch Coverage
The fund increased its payout to investors to start off 2023, which was basically the opposite of what its peers were doing. Since the fund was hedged against interest rates, that could have given them more confidence. The actual NAV rate itself still isn't too high either, at 8.46%. However, the latest report shows us that NII has declined as expected.
If we annualized the latest figure, we would see that NII declined by almost 19%. Based on the latest monthly distribution, the fund would pay out $0.804 every six months, against the $0.42 in NII per share reported, which would give us NII coverage of around 52%.
With deleveraging during this period, NII should decline again going forward. That would suggest coverage will slip once again going forward while they are already showing weak coverage. Therefore, if you are investing solely for the expectation that PTA is earning its distribution rate right now and not expecting a cut, that isn't the case. A distribution cut is a very real possibility.
What NII doesn't reflect, though, is the impact of interest rate swaps because that goes into the capital gains bucket. In the last six months, they realized a loss of $74.4 million, but the swap contract gains at least partially offset that. The results would have been even worse otherwise.
That said, what they realized in swap gains was offset by the unrealized losses in the swaps. Simultaneously, what they realized in losses was offset by sizeable unrealized gains. All in all, that's why we saw only slight declines in terms of total NAV returns during the six-month period reflected in this report, and these are the numbers to show what was going on.
PTA's Portfolio
The portfolio hasn't changed too drastically since our last update, aside from a few fewer positions that were wiped out involuntarily. The banking and insurance industries comprise nearly 70% of the fund's investments.
PTA Sector Breakdown (Cohen & Steers)
The fund also remains invested a fair bit outside of the U.S., though U.S. exposure is still the largest allocation by a wide margin.
PTA Geographic Breakdown (Cohen & Steers)
Unlike the Flaherty & Curmrine funds, they don't specifically list the metric for fixed-to-float exposure, which would be very handy. Currently, they do list that only around 3% of their portfolio is in floating-rate preferred. That's why they've taken interest rate changes so hard, with the vast majority of their portfolio dedicated to fixed-rate investments. Assuming the fixed-to-float securities aren't redeemed immediately by some of their holdings, we should see floating rate exposure increase going forward.
Looking at FFC again, they list that 84% of their portfolio is invested in fixed-to-float. Using some conjecture and taking a quick rundown of each position in PTA would suggest they also have a portfolio that could mirror close to the same sort of weighting.
The portfolio's credit quality isn't necessarily terrible, with a fair bit allocated to investment-grade categories. Then again, two of the banks that failed were also considered investment grade.
The fund's largest holdings also provide some comfort as it includes globally systematically important banks. JPMorgan ( JPM ), Wells Fargo ( WFC ), Bank of America ( BAC ) and Citigroup ( C ) are all among the largest preferred positions for PTA. Seeing one of these banks fail would certainly mean we are in quite an economic predicament.
Conclusion
Investing in a preferred fund going forward is betting on no more large regional bank failures going forward. Any more failures, and we could see another plunge for these types of funds. Additionally, if one believes that interest rates are going to rise materially from here - beyond the two that are anticipated - preferred and income funds should still be avoided.
However, with a solid discount and an apparent stabilization of banks for now, it would appear that preferred investments could reward investors going forward. PTA might not reach its pre-2022 or banking crisis highs due to deleveraging, but that doesn't mean the fund can't produce respectable returns in the future. Admittedly, the past certainly has been a rough ride.
Rate cuts would be even better for the fund, but we shouldn't anticipate that happening this year. At the least, we should be nearing the peaks for this interest rate hiking cycle, leading to a brighter future for PTA.
For further details see:
PTA: Attractive Discount With A Brighter Looking Future