Preferred CEFs Asset Coverage Update

ETFS

This article uses market data as of Tuesday close.

A sharp drawdown period for preferred stocks has hammered asset coverage and increased leverage across the CEF sector. Given the sharp losses in the sector, asset coverage may be the last thing on investors’ minds. Asset coverage, however, is key in the funds’ ability to sustain distributions. This is because of the conditions that the Investment Company Act of 1940 imposes on funds.

In the preferred CEF sector, we like the Nuveen Preferred and Income 2022 Term Fund (JPT) which appears the safest in terms of asset coverage. It should also benefit from the tailwind of discount accretion to zero. As of Tuesday close, the discount was 6.9% well wider of the 3% sector average. As with all term funds, however, investors carry reinvestment risk in the sense they cannot lock in the cash at an attractive yield for as long as they can in a perpetual fund.

Asset Coverage Review

Section 18 of the 1940 Act is, no doubt, dear to all CEF investors, however, we will spare readers the actual language of the Act. One goal of Section 18 is to protect senior security holders of the fund by limiting the fund’s ability to pay distributions to common shareholders in certain instances as this would dilute their claims on fund assets.

The basics of this part of the law is that if a CEF has issued debt, then it has to maintain at least 300% asset coverage (or at most 33.3% leverage) in order to pay out a distribution. We will ignore the preferred requirement in this context since none of the preferred CEFs have issued preferred stock.

This seems pretty clear-cut, however this is precisely where it gets complicated. The key question is – what counts as debt? Senior notes are clearly debt, but what about instruments like repos, tender option bonds, mortgage dollar rolls and bank loans/credit lines/facilities/borrowings?

Repos, tender option bonds and mortgage dollar rolls aren’t debt which means they are out of scope for Section 18. Bank borrowings are debt – this is intuitive but we can also verify this by looking at how some funds treat bank borrowings. Kayne Anderson which use bank loans and bank credit facilities as a source of leverage state the following in one of their annual reports :

Under the 1940 Act, the Company may not declare or make any distribution on its common stock nor can it incur additional indebtedness if, at the time of such declaration or incurrence, its asset coverage with respect to senior securities representing indebtedness would be less than 300%. For purposes of this test, the Credit Facility and the Term Loan are considered senior securities representing indebtedness.

Source: SEC

This seems pretty clear-cut so far, however, this is where it gets weird. Cohen & Steers manages a number of CEFs which use bank credit facilities. This is what they say in their 20-March update.

If leverage exceeds 50.0% of a fund’s total managed assets, the fund can no longer declare or pay a distribution.

Source: Cohen & Steers

These two large fund companies appear to disagree on how to treat credit facilities in their ability to pay out distributions on their CEFs. Kayne Anderson says the figure is 300% and Cohen & Steers says the figure is 200% for debt. An answer potentially lies in whether or not the fund is able to segregate assets in the amount sufficient to “cover” the bank liability. If the fund has done this then magically the bank liability no longer counts as a senior security under Section 18.

Of course, the bank itself would not be satisfied with 100% coverage i.e. zero haircut on the loan and would demand a much higher figure. However, now that the fund can avoid the Section 18 conditions, CEF investors are in a sense flying blind because the fund is no longer constrained by the Act’s distribution condition. This may seem attractive – after all CEF investors want the fund to keep paying out distributions. However, without the transparent 1940 Act conditions what we have are non-transparent privately negotiated bank conditions. As far as Cohen & Steers funds, they have made it clear that the hard figure for them is not 300% but 200%, however, normally funds do not communicate these figures.

CEF Preferred Asset Coverage Big Picture

In the chart below we estimate asset coverage figures across the entire sector based on previously published figures and current NAVs. The assumption underlying these estimates is that the capital structure of the funds has not changed. What we see is that all but one fund is trading at an asset coverage below 300%. This suggests that unless funds have gone the segregation route, they may be in danger of not being able to make distributions. In the sections below, we go a bit deeper into each fund family in the sector.

Source: ADS Analytics LLC, SEC

Cohen & Steers Funds

The two funds from this management company are:

  • Select Preferred and Income Fund (PSF)
  • Limited Duration Preferred and Income Fund (LDP)

These funds appear to be in decent shape with asset coverage north of 265%. The company has also done a better job in communicating with investors. According to their 20 March release they have not reduced the leverage in their preferred funds. They also published asset coverage figures which tie out with ours for the same date giving us more confidence in our estimates for these two funds.

Both funds have seen below average NAV drawdowns during this market episode. At current discounts of 0.3% and 5.2% for LDP and PSF, respectively, we find PSF marginally more attractive though the distribution coverage of both funds is fairly low at around 75%.

Source: ADS Analytics LLC, SEC

John Hancock Funds

The four John Hancock funds are:

  • John Hancock Premium Dividend Fund (PDT)
  • John Hancock Preferred Income Fund (HPI)
  • John Hancock Preferred Income Fund II (HPF)
  • John Hancock Preferred Income Fund III (HPS)

These funds are a bit different from the rest of the sector in that they also hold common stocks and are overweight energy and utilities. Little surprise then that these funds have underperformed the sector in NAV terms by about 10% over the past year.

Our asset coverage figures put these funds in the danger zone even at the lower 200% target. We haven’t seen communication from the funds with regard to their leverage plans.

Source: ADS Analytics LLC, SEC

First Trust Funds

First Trust manages one fund:

  • First Trust Intermediate Duration Preferred & Income Fund (FPF)

The fund appears to be in decent shape so far at around 260% estimated asset coverage. The company updates the fund’s leverage status daily currently showing 29.98% leverage or 333% asset coverage. Why the discrepancy?

If we glance at current total managed assets published on the fund site, it comes to 1.4bn and if we use the current NAV, the previously published borrowing amount and the outstanding number of common shares (which haven’t changed) we get to a figure of 1.66bn estimated total assets. The discrepancy leads us to believe that the fund has deleveraged by about 260m or about 16%. This seems to be correct as the updated borrowing figure on the site of 410m is 236m below the previously published borrowed amount in October 2019. The fund last declared a distribution on March 19th at the same level as before. However, if our analysis is correct, then the fund may look to cut its distribution in line with its lower total assets. The fund’s discount of 4.8% is too tight versus the 3% sector average to wear this risk, in our view.

Source: ADS Analytics LLC, SEC

Flaherty & Crumrine Funds

Flaherty & Crumrine manage 5 preferred CEFs:

  • Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP)
  • Flaherty & Crumrine Preferred and Income Securities Fund (FFC)
  • Flaherty & Crumrine Total Return Fund (FLC)
  • Flaherty & Crumrine Preferred Income Fund (PFD)
  • Flaherty & Crumrine Preferred Income Opportunity Fund (PFO)

Three of the funds publish daily leverage updates which tie out with our estimates. All the funds have distribution coverage in the mid 90s. DFP is trading at the widest discount of 6.5% and the highest current yield.

Source: ADS Analytics LLC, SEC

Nuveen Funds

Nuveen has four funds:

  • Nuveen Preferred & Income Opportunities Fund (JPC)
  • Nuveen Preferred & Income Term Fund (JPI)
  • Nuveen Preferred & Income Securities Fund (JPS)
  • Nuveen Preferred and Income 2022 Term Fund (JPT)

Nuveen hasn’t updated their leverage figures since February month-end, however their figures are close to ours for that date which gives us some confidence. This doesn’t mean they are correct as of today, of course, since the company could have tweaked their capital structure.

There is a huge variation in the estimated asset coverage with JPC and JPS at around 220%. JPT, on the other hand, boasts enormous asset coverage due to its low leverage – the lowest in the sector. This makes sense as the fund is a term fund. Its discount of 6.9% is unusually large for a term fund. At this point, however, investors may be looking to lock in high yields for longer than 2 years which makes them overlook the fund.

Conclusion

There is surprisingly little visibility on asset coverage figures in the CEF space, particularly during such a volatile period where these metrics matter a great deal. Preferred sector CEFs could very well come through mostly unscathed and without any serious deleveraging, particularly if the market continues to recover from here and if the funds rely on the lower than the 300% asset coverage figure. As funds start to declare distributions over the coming weeks we will know more on this front.

Check out Systematic Income and get access to our unique suite of interactive tools that uncover the fund markets (CEFs, ETFs and mutual funds) as well as preferred stocks and baby bonds.

We are holding our maximum 20%-off subscription discount for the next few days.

Follow along with activist CEF investors, track UNII and coverage metrics, check out our target-yield portfolios and systematic strategies, slice and dice funds – and much more. 

Check us out on a no-risk basis - sign up for a 2-week free trial!

Disclosure: I am/we are long JPT, JPI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Products You May Like

Articles You May Like

Which bills to pay during the coronavirus pandemic
Mohamed El-Erian: The stock market could still go back down to new coronavirus lows
On Campus: Australian National University Democratizing Legal Disputes with Blockchain
Stocks got two positives Monday—drug industry breakthroughs and a more realistic government approach
Macy’s is the first of what could be a retail and energy purge from the S&P 500

Leave a Reply

Your email address will not be published. Required fields are marked *