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posted on 10 August 2016

It Feels Good To Be Preferred

by Ari Charney, Investing Daily

Investing Daily Article of the Week

We're stock pickers first and foremost. But we still think pooled securities such as mutual funds and ETFs have an important place in every investor's portfolio.

However, we'll admit to being frustrated by the fact that there are relatively few decent options for utility investors.

On the fixed-income front, for instance, our favorite utility bond ETF was shuttered last year. That really leaves only one investment vehicle that covers the space, albeit imperfectly: John Hancock Premium Dividend Fund (NYSE: PDT).

The closed-end fund, which specializes in preferred stock, offers a monthly payout with an enticing distribution rate of 6.8%. Even so, it's definitely not for everyone.

For one, the fund is not a utilities pure-play.

Preferred-share issuance is essentially dominated by two sectors: utilities and financials. That means the fund necessarily has substantial exposure to the financial sector, recently at about 36% of assets.

While utility preferreds and equities comprise nearly 46% of assets, PDT's financial-sector holdings offset some of the safety that utilities would normally provide during a protracted downturn.

Additionally, PDT employs significant leverage to boost its payout and returns. The fund's current leverage ratio is around 32%, which means that for every $1 of investable capital about $0.32 is derived from leverage.

Leverage can amplify performance during bullish periods, but takes a bite out of returns during bearish periods.

Nevertheless, the fund's veteran management team did an excellent job of ensuring the fund held its value during the last bear market. In 2008, when the market lost 37%, PDT ended the year down 22%.

Although the fund recently lost one of its two longtime managers, it's still led by a manager who's been with the fund for 14 years. So we would expect management to continue skillfully navigating a full market cycle.

Over the trailing 10-year period, PDT's net asset value (NAV) has grown 10.9% annually, and over the trailing five-year period the fund's NAV has grown 13.6% annually.

At the same time, one concern is that utilities have cut way back on preferred-share issuance in recent years, which could affect the fund's performance over the medium term.

Preferreds are considered a hybrid security, with characteristics of both debt and equity, and are typically issued by firms when they're uncertain about how the operating environment might weigh on their ability to shoulder the obligation of debt.

But in an era of historically low interest rates, the cost of capital is dirt cheap, and utilities don't need the flexibility afforded by preferreds. With rates looking likely to stay lower for longer, this situation may not change anytime soon.

Consequently, that could force management to lean more heavily on financial-sector preferreds, while concentrating their exposure to utility preferreds on just a handful of companies.

Beyond PDT's specific attributes, closed-end funds (CEFs) also aren't for everyone. CEFs are investment companies that actively manage pools of assets in a manner similar to mutual funds, but trade on the open market, just like exchange-traded funds (ETFs).

The latter quality can cause a CEF's unit price to deviate markedly from its net asset value (NAV). The same thing can happen with ETFs, though the difference is usually slight by comparison.

We actually like this aspect of CEFs, at least when they're trading at a discount to NAV. As value-conscious investors, we appreciate having an opportunity to buy a slice of assets below their market value.

But many CEFs trade at persistent discounts to NAV, and waiting for that gap to close can frustrate some longtime unitholders. Over the trailing three-year period, for instance, PDT has traded at an average discount of 9.5% to its NAV.

However, recent circumstances have pushed income-oriented securities higher, and PDT is no exception: It currently trades at a 1.7% premium to NAV.

Prospective investors should avoid buying a CEF at a premium. But it's not always enough to buy a CEF at fair value or even at a slight discount, given some CEFs' tendency to trade at wide discounts to NAV over the medium to long term.

So how should you gauge the level at which PDT offers a truly compelling value? One way is to look at the fund's average discount over longer-term periods.

Over the trailing six-month period, PDT traded at an average discount of 3.7% to its NAV, while over the past five calendar years it traded at an average discount of 6.9%.

Income-hungry investors should at least hold off until the fund trades at the former, while stingier investors should bide their time until the fund trades near the latter.

Those who want to monitor whether PDT is trading at a premium or discount to NAV can check its status at CEFConnect.

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