As a retiree, I am always looking for income opportunities that
are relatively low risk. Preferred stocks Closed End Funds (CEFs)
are often overlooked by investors and have the potential for higher
income than common stock funds. Like common stocks, most preferred
stocks bottomed in March of 2009 and have recovered nicely. Many of
the CEFs were selling at a premium to Net Asset Value ((
)) until June of this year, when fear of rising rates precipitated
another selloff. As a result of this decline, many of the CEFs are
now selling at a discount. Considering that many of the CEFs offer
high income (on the order of 7% to 8%), I decided to asses this
asset class for candidates to include in a retirement portfolio.
This article will review the risk versus reward over several time
periods and will also touch on some issues that could affect the
CEFs in the future.
First let's take a quick review of the characteristics of
preferred stocks. Many companies issue preferred stock since this
is one way corporations can raise money without diluting the number
of common shares. Preferred stock does not have voting rights but
usually has a much higher dividend than the common stock. The
dividend payment associated with preferred stock is not guaranteed
but the preferred stock holder must be paid before the common stock
holder can receive any dividends. Thus, preferred stock sits
between bonds and common stock in the capital structure. It is
senior to the common stock but will be paid after the interest on
bonds. Suspending payments on preferred stock is a last resort but
it is not considered a default like suspending payment to
After issuing a preferred stock, the price can fluctuate, with
one of the key factors being interest rates. If interest rates
rise, then the price of the preferred shares will likely drop
because investors will demand higher yields. Also, like a bond,
many of the preferred stock issues are callable at a specified date
in the future.
There are several closed end funds that invest primarily in
preferred shares. Using data from
.com, I selected candidates based on the following criteria:
- I wanted to analyze CEFs over a complete bear and bull market
cycle, so I chose CEFs that had a history going back to 12
October, 2007 (the start of the 2008 bear market)
- Distributions had to be at least 6%
- Premiums had to be less than 5%
- Market Cap had to be greater than $200M
- Average trading volume had to be greater than 50,000 shares
The following CEFs satisfied all of these conditions:
Flaherty & Crumrine Preferred Securities Income (
This CEF has a distribution of 8.8% and sells for a small
discount of 0.5%. It has typically sold at an average premium of
over 4% over the past 52 weeks. The fund was launched 10 years
ago and has a good long-term track record. Despite its high
distribution, it has used return of capital ((
)) in only one year since inception. The fund's portfolio
consists of 134 holdings, concentrated primarily in stocks of
banks, insurance companies, and utilities. It utilizes 34%
leverage and has an expense ratio (including interest payments)
John Hancock ((JH)) Preferred Income III (
This CEF has a distribution of 8.3% and is selling at a discount
of 1.6% (compared to a 52 week average premium of 1%). The fund
has 103 holdings focused mainly on utilities and banks, with
about 80% being US based. It had some destructive ROC during the
bear market of 2008 but generally has generated sufficient
earnings to cover distributions. It utilizes 33% leverage and has
an expense ratio, including interest payments, of 1.7%. Note that
two additional preferred stock CEFs are in John Hancock family:
JH Preferred Income (
JH Preferred Income II (HPF)
. These sister funds have similar portfolios and are highly
correlated with one another. Therefore, I only included HPS in my
analysis since it was the most liquid.
John Hancock Premium Dividend Fund (PDT).
This John Hancock fund is more diversified than the pure
preferred stock funds in the JH family. PDT consists of about 60%
preferred stock and the rest is in dividend-paying equities. It
is selling at a large discount of over 10% (which is a larger
discount than the average discount of 4%). The fund has a
distribution of 6.9%, none of which comes from ROC. It has over
100 holdings, with the utility sector accounting for almost half
of the total assets. The fund uses 33% leverage and has an
expense ratio of 1.8% (including interest payments).
Nuveen Preferred Income Opportunities (JPC).
This CEF sells at a discount of 8.8% (double the average discount
of 4.4%) and has a distribution of 8.1%. At the end of 2011, the
fund changed its investment strategy from a multi-sector fund to
a preferred stock fund. Investors should be aware of this
strategy change when evaluating this fund's longer-term
performance. The new strategy is generating sufficient income to
cover distributions so the fund is not using ROC. The fund has
234 holdings spread among insurance companies, banks, financials,
and real estate investment trusts. JPC utilizes 29% leverage and
has an expense ratio of 1.8% (including interest payments).
Nuveen Quality Preferred Income (JTP).
This CEF sells at a discount of 10.6% (over three times the
average discount of 3.2%) and has a distribution of 7.6%. It has
200 holding, primarily in the insurance, commercial bank, and
financial sectors. It employs 29% leverage and has an expense
ratio of 1.8%, including interest payments. Another sister fund,
Nuveen Quality Preferred Income 2 (JPS)
has a similar portfolio that is highly correlated with JTP.
Therefore, JPS was not included in the analysis.
There are also preferred stock Exchange Traded Funds (ETFs).
These funds differ from CEFs in that they passively track an index
rather than being actively managed. Also, the ETFs do not use
leverage, so typically they are less volatile and have lower
expenses than their CEF counterparts. I included the largest
preferred stock ETF in the analysis so I could compare the ETF
performance with CEF performance. The ETF selected was:
iShares S&P U.S. Preferred Stock Index
This ETF holds 200 preferred stocks, with about 75% being
domiciled in the United States. The vast majority of the holdings
are from the financial sector. The fund has a low expense ratio
of 0.48% and yields 5.8%.
Since preferred stock has attributes of both bonds and stocks, I
also included the following ETFs in the analysis for reference:
SPDR S&P 500 (SPY).
This ETF tracks the S&P 500 equity index and has a yield of
iShares Barclays 20+ Year Treasury Bond (TLT)
. This ETF tracks the performance of long-term treasury
To analyze risks and return, I used the Smartfolio 3 program (
.com) over a complete bear-bull cycle (from 12 October 2007 to the
present). The results are shown in Figure 1, which plots the rate
of return in excess of the risk free rate of return (called Excess
Mu on the charts) against the historical volatility.
(click to enlarge)
Figure 1. Risk versus Reward over bear-bull
As is evident from the figure, there was a relatively large
range of returns and volatilities. For example, FFC had a high rate
of return but also had a high volatility. Was the increased return
worth the increased volatility? To answer this question, I
calculated the Sharpe Ratio.
The Sharpe Ratio is a metric developed by Nobel laureate William
Sharpe that measures risk-adjusted performance. It is calculated as
the ratio of the excess return over the volatility. This
reward-to-risk ratio (assuming that risk is measured by volatility)
is a good way to compare peers to assess if higher returns are due
to superior investment performance or from taking additional risk.
In Figure 1, I plotted a red line that represents the Sharpe Ratio
associated with SPY. If an asset is above the line, it has a higher
Sharpe Ratio than SPY. Conversely, if an asset is below the line,
the reward-to-risk is worse than SPY. Similarly, the blue line
represents the Sharpe Ratio associated with TLT.
Some interesting observations are apparent from Figure 1. Over
the complete cycle, long-term bonds had the best risk-adjusted
return. This is because they held up better than equities during
the horrendous bear market of 2008. A couple of CEFs, DDT and FFC,
had about the same Sharpe Ratio as TLT. All the preferred stock
CEFs had better risk-reward performance than either SPY or PFF.
Overall, the CEFs had high volatility but also delivered high
performance. Based on this chart, the preferred stock CEFs would
have made good additions to your portfolio.
I next looked at the past 3 year period to see if the
outperformance has continued. The results are shown in Figure 2.
What a difference a few years made! Over the past 3 years, the SPY
has been in a rip-roaring bull market and neither preferred stock
CEFs nor the bond funds could keep pace.
(click to enlarge)
Figure 2. Risk versus Reward over 3 years
The data shown in Figure 2 is more aligned with expectation, as
the performance of the preferred stock CEFs was between that of
bonds and equities. Also evident from the figure is that the
preferred stock CEFs have relatively high volatility, about the
same as the SPY. On the other hand, the preferred stock ETF, PFF,
had substantially lower volatility but also had a lower
risk-adjusted return than the CEFs. Over this period, JPC led the
pack with about the same Sharpe Ratio as the SPY. FFC was not a
standout during this period but did continue to perform relatively
well. The decision whether or not to invest in preferred stock CEFs
was not as clear-cut as it was for the longer time period.
The investment landscape became even murkier in the recent past.
Since June of this year, the fear of rising rates has taken its
toll on preferred stocks, causing them to give back most of the
year to date gains. To get a more near-term view, I ran the
analysis from the beginning of 2012 to the present, a little over
1.5 years. This data is presented in Figure 3. The near term
results are similar to the 3 year data. The performance of the
preferred stock CEFs is better than long-term bonds but worse than
the S&P 500. The volatility of these CEFs is on the same order
as the stock market.
(click to enlarge)
Figure 3. Risk versus Reward since Jan 2012
Which is better, the preferred stock ETF or the CEFs? As you
have seen, it depends on the time period under analysis. Over the
longer term, CEFs had better risk-adjusted performance but over the
near term, PFF has a much higher Sharpe Ratio. So it really depends
on the market conditions that you expect in the future.
Before leaving this analysis, there are a couple of additional
factors that you should consider. In addition to interest rate
risk, preferred stocks also have a re-finance risk. Since many
preferred stocks are callable, the issuing company can call their
preferred stock and re-issue at a lower interest rate. This is
especially true in a low interest rate environment like we have had
recently. In 2012, $13 billion of preferred stock was redeemed
(with average coupon rate of 7.16%) and replaced with issues that
had an average coupon rate of 6.37%. This puts downward pressure on
Also, as part of the Dodd-Frank Act, non-perpetual preferred
issues can no longer be used to satisfy Tier 1 capital
requirements. The banks must phase out the use of these preferred
stocks by 2015 and replace them with other forms of capital. One of
the nuances of the Dodd-Frank Act is that it will likely allow some
bank preferred trust issues to be recalled earlier than originally
planned. This too will increase the headwinds against preferred
The bottom line is that preferred CEFs were once excellent
candidates to add to retirement portfolios. They were always
volatile but since they were relatively uncorrelated with other
assets, they provided diversification as well as high income.
However, in the current environment of potentially rising rates and
new regulations, caution is advised. You must carefully evaluate
the risk and rewards relative to your investment objectives. Using
CEFs for your preferred stock exposure can be rewarding but it is
not for the fainthearted.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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