This article was first published to Systematic Income subscribers and free trials on May 3.
The CEF Preferred sector (i.e. the preferred shares issued by CEFs) is often overlooked by income investors due to its below-average size and liquidity. However, the sector has historically provided diversification, resilience, quality and decent returns. In this article, we provide an update for the sector along with our picks.
The CEF Preferred sector is comprised of three sub-sectors: CEF Preferred CLOs, CEF Fixed Income Securities and CEF Equity Securities. CLO CEF prefers is a riskier and more complex sub-sector and we will discuss this in another article. Here, we focus on low-risk fixed income and CEF preferred stocks.
These three subsectors have significantly different risk profiles, with CEF preferred stocks being the most resilient due, typically, to very high average asset coverage and low CEF leverage. CEF preferred shares are also attractive because most have investment grade ratings and have no debt (i.e., pensions, credit facilities or baby bonds) ahead of preferred shares in the capital structure. CEF fixed income preferred stocks tend to have lower asset coverage and often higher debt than preferred stocks. However, they also tend to trade at higher yields.
A number of key themes are worth highlighting.
First, the sector has has held up relatively well so far this year.
This is partly due to the sector’s relatively high coupon and yield levels, especially compared to other stocks of similar quality. Higher starting yields have the effect of shortening duration, making equities less sensitive to rising interest rates.
Another reason is that these stocks tend not to be held by passive ETFs due to their relatively low issue amounts, which prevents them from being included in relevant indices. This makes them less vulnerable to passive outflows such as the nearly $2.5 billion in year-to-date passive ETF outflows in the sector.
Finally, CEF’s favorite stocks remain a relatively niche sector, and investors with allocations to the sector are likely to be those with the highest conviction and “strongest hands”, making them less likely to sell and more likely to buy during draws.
Another theme was the ongoing issue of common stock on certain funds. All other things being equal, the issuance of additional common shares increases the fund’s net assets which, in turn, increases equity/preferred coverage.
For example, Gabelli Utility Trust (GUT) recently increased its outstanding common shares from 54 million to 64 million, adding approximately $40 million in net assets. A number of other Gabelli funds have done the same. This improves the position of the privileged, making them less vulnerable to losses, all other things being equal.
It’s important to point out that while issuing additional common stock is nice to see, it doesn’t always lead to higher preferred stock coverage. Indeed, the fund can also increase its borrowing, either through debt or through preferred shares. This is an especially common theme for CLO preferred shares where funds like to keep their leverage profile fairly stable while issuing additional common stock. This means that it is usually only CEFs with outstanding inherited preferences, such as Gabelli preferences, that benefit from this dynamic.
A third theme is the deleveraging before favorites in the capital structure. For example, the Highland Income Fund (HFRO) had a $200 million facility before the preferred shares, which has now disappeared. RiverNorth/DoubleLine Strategic Opportunity Fund (OPP) had a $21 million facility in front of the Preferred which also disappeared, being replaced by another Preferred. This dynamic improves the position of the privileged since all the assets are now directed towards the protection of the privileged rather than going first to repay the debt.
In this section, we highlight a few titles that look attractive at the moment.
the Gabelli Dividend & Income Trust 4.25% Series K (GDV) is trading at a yield of 5.73%. The stock has a relatively low coupon, which has caused it to underperform this year. Investors worried about higher interest rates should opt for the 5.51% yielding Series H (GDV.PH) instead.
These two favorite stocks have a comically high asset coverage figure of 755%. An intuitive way to think about this is that fund assets must fall more than 87% before the preferred stock asset coverage drops below 100%, i.e. before fund assets fall below the preferred stock liquidation preference.
GDV is an equity CEF with the largest sector holdings in the financials, healthcare and food & beverage sectors. The leverage of the fund is around 15%. GDV.PK is rated A3 by Moody’s and has no debt before it in the capital structure.
the Highland Income Fund 5.375% Series A (HFRO.PA) is trading at a yield of 6.02% and is rated A1 by Moody’s. The stock has a whopping 839% asset coverage (meaning the fund’s assets need to drop 88% before it hurts the liquidation preference). HFRO has large, unusual and questionable holdings, such as its two REIT subsidiaries and a whole lumber pile in East Texas, as well as more traditional assets such as bank loans. Even if we reduce all non-loan assets to zero and stress test loan holdings by the historic recovery of around 70%, preferred stocks are still full.
the RiverNorth Opportunities Fund, Inc. 6.00% Series A (RIV.PA) is an A1-rated preferred trading at a yield of 6.42%. When the stock was recently issued, we had a fairly negative view of it, citing the built-in leverage of its CEF holdings, its low level of income generation (which would lead to a drop in NAV at over time, reducing asset coverage) and the fact that there was debt before the preference.
Nothing changes our mind like improved performance. Since its issuance just a few weeks ago, the stock has fallen to a stripped price of $23.35, pushing its yield up 0.4%. At this level, the stock has the highest yield of CEF’s preferred equity and fixed income universe, although it does not have the strongest risk profile. It currently has an asset coverage level of 296%.
About two-thirds of the RIV is allocated to other CEFs and another third to SPACs. Although CEF holdings result in additional leverage, the SPAC position is relatively low in volatility as they typically trade not far from their $10 price level.
Take away food
CEF’s preferred equity sector remains attractive as part of a broader income portfolio. It can offer resilience, diversification, quality and decent yields – an attractive combination in a challenging market environment for income assets, especially with the added uncertainty of rising recession estimates over the coming quarters.