In the last couple of months I’ve written a few posts here (link) about how I’ve been increasing the allocation to floating rate securities in my debt portfolio in anticipation of rising interest rates -- floating rate senior loans, both an unleveraged mutual fund and leveraged closed end funds, augmented with moderate positions in individual floating rate equity preferred stocks and the variable rate bond CEF GFY. My FR exposure is now about 10% of my debt portfolio.
However, since some market mavens think that the sluggish economic recovery will keep the Fed’s interest rates low for some time, perhaps years, not only am I holding firm on most of my fixed rate debt (my last post on the Pimco CEFs managed by Bill Gross is here) I’ve actually added to it a bit in the past couple of weeks. I’d like to think this approach resembles more a barbell than a dumbbell.
What continues to attract me are so-called preferred securities, a motley crew that consists of both traditional equity preferred stocks and the somewhat newer so-called hybrid preferreds, which are actually bonds, either de jure (exchange-traded bonds) or de facto (trust preferreds and trust certificates). The attraction is their high yield, pure and simple. The hybrid preferreds, what I prefer to call exchange-traded debt, are mostly fully taxable but “provide the highest yields of any investment grade fixed income security,” according to preferred fund manager Donald Crumrine in a recent interview (link) published by the Wall Street Transcript. Moreover, the equity preferreds are taxed at the qualified dividend rate, currently 15%, as are also trust preferreds from foreign banks in what appears to me to be a strange quirk in the tax laws.
There are some newer ETFs in preferreds but I prefer the CEFs for the enhanced yields that leverage provides. I figure if I’m going to take the interest rate risk of preferreds why not double down and add some leverage to juice the yields. There are three families of preferred CEFs – Nuveen, John Hancock, and Flaherty & Crumrine, each with four offerings. At my recent look at the metrics of all of them, which I array in table form, I once again find the Nuveen funds most attractive in the metrics I value, which include a high ratio of net investment income to distribution, positive undistributed net investment income worth at least a month’s distribution, sizeable discount to net asset value, moderate leverage, no destructive return of capital, and good average portfolio credit. At this point in time, I like the Nuveen trio of JTP, JPS, and JHP best, and have recently found that JPS, which happens to be the largest of the three, has had the most attractive combination of size, discount, and distribution, so it’s the one I’ve been adding to of late.
Since the relative attractiveness of the CEFs can vary over short periods of time, especially since the discount can change daily, when I decide to add to a position I might find one CEF relatively more attractive than the others on that day. In this Nuveen family, I also hold JTP.
As of yesterday, JPS sports an annualized distribution of 8.1% trading at an 8.0% discount to net asset value. This discount is well below the 5-year average, usually an attractive feature when other investment indicators are favorable. Nuveen represents at its web site that about 37% of the JPS holdings are equity preferreds, which are taxed at the 15% rate. My back-of-the-envelope calculation is that this translates to a fully taxable equivalent yield of about 9.0%. I’ve got moderate credit risk, more so on the equity preferreds, significant interest rate risk, and the looming phase-out of bank trust preferreds (which will offer capital gains to the extent that the CEFs’ cost bases are below par but reduce the investable universe of hybrid preferreds). But for the high yield, I’m staying modestly invested in this space with some alpha money.
I’m an individual investor with no background in finance or securities, writing things down to help organize and clarify my thinking. Of course, nothing I say constitutes investment advice of any kind – merely an account of my personal observations and decisions. My core portfolio is a conservative and diversified mix of equity and debt mutual funds, ETFs, and some closed-end funds (CEFs) across investment styles, management firms, and accounts, and I invest a relatively small amount (about 10%) somewhat more aggressively in the perhaps ultimately futile pursuit of alpha.