FFC: Portfolio Property Seem Overpriced, Some Revenue-Taking May Be Sensible

The Flaherty & Crumrine Most well-liked and Earnings Securities Fund (NYSE:FFC) is a closed-end fund that has lengthy been a reasonably in style selection amongst traders who’re looking for to earn a excessive stage of earnings from the belongings of their portfolios. Sadly, this fund suffered severely over the previous two years as its excessive stage of leverage resulted in pretty important losses because the Federal Reserve scaled again on quantitative easing and cash printing in favor of a tighter financial setting. In consequence, the fund was compelled to chop its distribution a number of instances. Proper now, the Flaherty & Crumrine Most well-liked and Earnings Securities Fund has a 6.75% yield, which isn’t significantly better than the 6.67% present yield of the iShares Most well-liked and Earnings Securities ETF (PFF). That is disappointing, because the exchange-traded fund doesn’t use leverage to artificially increase the yield from the securities in its portfolio. It nearly goes with out saying that the fund’s distribution yield is considerably decrease than the yield at present supplied by different most popular inventory closed-end funds:

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The distinction in yields between this fund and its friends from different fund homes is kind of stark. This isn’t a case the place we’re solely speaking about a number of foundation factors in yield, which can usually be irrelevant to most traders. On the floor then, the fund’s friends seem like providing a significantly better funding proposition contemplating that each one 5 of those funds spend money on very comparable belongings. That admittedly doesn’t imply that the Flaherty & Crumrine Most well-liked and Earnings Securities Fund is a worse fund than its friends because it may make up for the decrease yield with stronger share worth appreciation, however it isn’t an excellent signal.

As common readers could recall, we final discussed the Flaherty & Crumrine Most well-liked and Earnings Securities Fund in the course of November. The fund’s efficiency since that point has been reasonably spectacular. As we are able to see right here, the fund’s shares have appreciated by 8.14%, which is a greater efficiency than the 7.04% achieve of the ICE Trade-Listed Most well-liked & Hybrid Securities Index, which is tracked by the iShares Most well-liked & Earnings Securities ETF:

That is usually what we’d anticipate to see from a leveraged most popular inventory fund. In spite of everything, leverage will are likely to amplify upward actions within the worth of the belongings within the fund’s portfolio. This is similar leverage that seemingly prompted issues for this fund again in 2022 and 2023 because it amplified the fund’s losses as most popular inventory costs declined.

In earlier articles, I’ve identified that traders in closed-end funds such because the Flaherty & Crumrine Most well-liked and Earnings Securities Fund sometimes do significantly better than the share worth efficiency alone would counsel. It’s because these funds are likely to pay out all of their funding earnings to the shareholders within the type of distributions whereas merely making an attempt to maintain their web asset values at a considerably steady stage. That is what leads to the very excessive yields which can be boasted by these funds. On account of this, we should always all the time contemplate the distributions {that a} fund pays out in any evaluation of its efficiency. Once we do that, we are able to see that traders within the Flaherty & Crumrine Most well-liked and Earnings Securities Fund loved a ten.05% whole return. This compares fairly favorably to the 8.31% whole return that traders within the index obtained:

That is actually a formidable return over two and a half months. Nonetheless, it’s value noting that each one three of the John Hancock most popular inventory funds listed within the desk above managed to outperform this fund by a substantial margin:

Thus, this efficiency comparability seems to counsel that traders who want to personal most popular shares proper now could be higher off with any of the John Hancock funds than the Flaherty & Crumrine Most well-liked and Earnings Securities Fund. That is notably true once we contemplate that almost all traders who buy most popular shares are doing so as a way to obtain a excessive stage of earnings.

It may be a good suggestion to pare again any positions that you might have within the Flaherty & Crumrine Most well-liked and Earnings Securities Fund proper now and never due to the fund’s underperformance relative to its friends. Earlier right this moment, the Federal Open Market Committee concluded its coverage assembly and strongly implied that the market is mistaken in regards to the price cuts that it has been pricing in. It was these expectations that had been accountable for this fund’s rally over the previous few months and if the Federal Reserve’s statements are to be believed, then the belongings held by the fund are considerably overvalued and can decline within the very close to future. As such, it may be a good suggestion to take some earnings and redeploy belongings into extra productive makes use of.

About The Fund

In accordance with the fund’s website, the Flaherty & Crumrine Most well-liked and Earnings Securities Fund has the first goal of offering its shareholders with a excessive stage of present earnings whereas nonetheless making certain the preservation of its principal. It is a very cheap goal contemplating the fund’s technique. As is normally the case with Flaherty & Crumrine funds, the web site does an excellent job of explaining the fund’s technique. Here’s what it states:

The Fund’s funding goal is to offer its widespread shareholders with excessive present earnings in line with preservation of capital.

Below regular market situations, the Fund invests a minimum of 80% of its Managed Property in a portfolio of most popular and different income-producing securities. Most well-liked and different income-producing securities could embrace, amongst different issues, conventional most popular inventory, belief most popular securities, hybrid securities which have traits of each fairness and debt securities, hybrid securities which have traits of each fairness and debt securities, contingent capital securities, subordinated debt and senior debt. “Managed Assets” are the fund’s web belongings, plus the principal quantity of loans from monetary establishments or debt securities issued by the Fund, the liquidation desire of most popular inventory issued by the Fund, if any, and the proceeds of any reverse repurchase agreements entered into by the Fund.

The Fund will make investments, underneath regular market situations, a minimum of 25% of its whole belongings within the financials sector, which for this goal is comprised of the banks, thrifts & mortgage finance, diversified monetary companies, finance, client finance, capital markets, asset administration & custody, funding banking & brokerage, insurance coverage, insurance coverage brokerage and actual property funding belief industries.

That is all fairly commonplace for a fund that invests primarily in most popular shares. The fund is mostly invested because it claims above. The fund’s annual report states that its asset allocation as of November 30, 2023 was the next:

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That is very completely different from what CEF Join and Morningstar record on their web sites for the fund’s asset allocation, however I’m usually inclined to think about the data in a fund’s annual report back to be extra authoritative than third-party sources. As I’ve identified in a number of earlier articles, some on-line sources contemplate most popular inventory with a maturity date to be a bond even though most popular securities occupy a special place in an organization’s capital stack. In spite of everything, within the occasion of chapter or liquidation, bondholders have to be repaid in full earlier than the holders of most popular inventory are eligible to obtain any cash.

Contingent capital securities are an attention-grabbing kind of safety that was created following the monetary disaster in 2007 and 2008. In brief, they’re a fixed-income safety that has a built-in characteristic that leads to homeowners of the safety struggling a loss if some occasion occurs. Nuveen, which is pretty well-known for its fixed-income funds, has an excellent description of those securities posted on its website. That web site supplies this common description:

However why are CoCos “contingent?” Due to a characteristic that mechanically imposes a loss on the investor ought to an issuer’s capital fall under a predetermined threshold – sometimes 7% of its whole risk-weighted belongings in a “high trigger” construction and 5.125% in a “low trigger” construction. When this happens, relying on the construction, there are three attainable outcomes:

1. The safety is transformed to widespread fairness,
2. The investor is compelled to imagine a brief write down of the safety’s worth,
3. The investor is compelled to imagine a everlasting write down of the safety’s worth.

The fundamental goal of those securities is to scale back the chance {that a} financial institution would require a taxpayer-funded bailout, which might appear to be a pure response to the occasions that occurred round that point.

The rationale that that is vital with respect to this fund is that the Flaherty & Crumrine Most well-liked and Earnings Securities Fund has 18.5% of its belongings invested in these securities, as already proven. These securities are clearly going to be riskier than abnormal company bonds and even most popular shares that shouldn’t have a “loss sharing” attribute. The yield on them will naturally be increased than abnormal company bonds as a way to compensate traders for the upper threat, however it’s nonetheless vital that individuals shopping for this fund understand that just about the entire securities that it holds are going to have a considerably increased threat of loss than the securities which can be held by an investment-grade bond fund.

Happily, the fund does take some steps to scale back the general dangers that any particular person safety presents to its portfolio as an entire. For starters, the fund has roughly 226 particular person issuers represented within the portfolio. This could end in no particular person issuer accounting for an outsized proportion of the fund’s total portfolio. That is largely the case, however we are able to nonetheless see a number of issuers which have a big sufficient illustration within the fund that they shouldn’t be ignored:

In lots of fixed-income funds, we don’t see any particular person issuer account for greater than 2% of the fund’s whole belongings. This one has quite a few issuers accounting for greater than that stage, so it does have a bit extra focus of belongings than another fixed-income funds. With that mentioned, there may be nothing bigger than 5% of whole belongings right here, which is roughly the purpose at which an asset begins to reveal the portfolio to company-specific dangers. For essentially the most half, there seems to be ample diversification throughout the fund to guard traders from an occasion that would trigger the securities issued by any given firm to say no independently of the market as an entire. We will nonetheless see important publicity to the banking and insurance coverage sectors right here, so a monetary disaster or one thing like that will nonetheless have a major affect on the fund’s portfolio however it is a downside that each most popular stock-focused closed-end fund has so that’s not a criticism about this specific fund.

It’s value noting that the Federal Open Market Committee in its statements right this moment excluded statements that the “U.S. banking system is sound and resilient,” which had been current in its ready remarks following earlier conferences. Zero Hedge jumped on this exclusion with a reasonably snarky comment:

Does the Fed not saying that “the U.S. banking system is sound and resilient” imply the banking system is not sound and resilient, or was it only a lie earlier than to persuade the inhabitants of one thing which was not the case?

In earlier articles on the Flaherty & Crumrine Most well-liked and Earnings Securities Fund, I identified that the banking system is sitting on a really excessive stage of unrealized losses that had been brought on by the speedy rise in rates of interest over the previous few years. These losses successfully put any financial institution vulnerable to collapse within the occasion of one thing that requires it to provide you with giant quantities of money at a second’s discover. One instance of such an occasion could be a financial institution run, which is the occasion that prompted Silicon Valley Financial institution to break down final March. The Federal Reserve did put an emergency lending program in place to forestall the additional collapse of any financial institution, however this program ends in March. The central financial institution has lately acknowledged that it intends to proceed with the shutdown of this emergency lending program, which may end in heightened instability within the monetary system. Once we mix this with growing levels of delinquencies at a number of the nation’s banks, there could possibly be a cause why the Federal Reserve noticed match to omit that individual assertion from its ready remarks. I’m actually not predicting any form of shock like what occurred again in 2007 and 2008, however the dangers of being a most popular stockholder in banks may be increased going ahead than it has been over the previous yr.

The Fund And Curiosity Charges

As talked about within the introduction, the Flaherty & Crumrine Most well-liked and Earnings Securities Fund delivered very sturdy worth appreciation over the previous few months. This was largely because of long-term rates of interest declining since mid-October 2023. As we are able to see right here, the yield of the ten-year U.S. Treasury word peaked on October 19, 2023. It has usually been declining since that point:

As costs and yields transfer in reverse instructions, because of this the value of the bond went up because the yields declined. When the ten-year Treasury word goes up in worth, it tends to hold all fixed-income belongings up with it. This contains most popular shares and contingent capital securities, reminiscent of those held by this fund. We will see this mirrored within the fund’s share worth efficiency. As we are able to see right here, shares of the Flaherty & Crumrine Most well-liked and Earnings Securities Fund have appreciated by 20.97% since October 19, 2023:

That is actually a really respectable return from any fixed-income asset over a three-and-a-half-month interval. The rationale for that is the market strongly anticipating that the Federal Reserve will quickly minimize rates of interest in 2024. As we are able to see right here, the market is at present anticipating that the federal funds goal price shall be 375 to 400 foundation factors on the finish of 2024:

This could require six price cuts from the present 525-550 foundation level vary. That is what’s at present priced into fixed-income securities. If the Federal Reserve doesn’t minimize rates of interest to that diploma by the top of the yr, it strongly means that the securities held by the fund are overpriced and can decline in worth.

The Federal Open Market Committee met earlier right this moment. As anticipated, it opted to maintain the federal funds price on the 525-550 basis-point vary that it has been at since July 2023. Extra importantly, the Federal Reserve made some feedback that strongly prompt that it’s going to not minimize rates of interest to wherever close to what the market is pricing in. The financial institution’s ready assertion included the next remark:

The Committee doesn’t anticipate will probably be acceptable to scale back the goal vary till it has gained better confidence that inflation is transferring sustainably towards 2 p.c.

This appears to suggest {that a} March price minimize will not be notably doubtless. That signifies that as a way to meet the market’s expectations, the Federal Reserve must cut back the federal funds goal vary at each single assembly over the rest of the yr. That doesn’t appear notably doubtless, particularly since it will start going through criticism from either side throughout a presidential election marketing campaign. The incumbent social gathering would criticize it as a result of price cuts of that diploma would require admitting that the economic system is in a recession. The opposition social gathering’s criticism would revolve round making an attempt to spice up asset costs as a way to make People who personal shares really feel higher about their wallets. The Federal Reserve will most likely try to keep away from such publicity from politicians operating for workplace if it might keep away from such.

For his or her half, the members of the Federal Open Market Committee remained steadfast of their expectation that there shall be a most of three price cuts this yr, with the primary one coming someday within the second half of the yr. That situation will nearly actually stress shares of this fund and trigger them to surrender a few of their current beneficial properties. Buyers could wish to take a few of their beneficial properties now earlier than the decline begins in earnest.

Leverage

As is the case with most closed-end funds, the Flaherty & Crumrine Most well-liked and Earnings Securities Fund employs leverage as a technique of boosting the efficient yield of the belongings in its portfolio. I defined how this works in my earlier article on this fund:

Mainly, the fund is borrowing cash and utilizing that borrowed cash to buy most popular shares and different income-producing securities. So long as the bought securities have a better yield than the rate of interest that the fund has to pay on the borrowed cash, the technique works fairly effectively to spice up the efficient yield of the portfolio. As this fund is able to borrowing cash at institutional charges, that are significantly decrease than retail charges, that can normally be the case.

Sadly, the usage of debt on this trend is a double-edged sword. It’s because leverage boosts each beneficial properties and losses. As such, we wish to be sure that the fund doesn’t make use of an excessive amount of debt as that will expose us to an excessive amount of threat.

As of the time of writing, the Flaherty & Crumrine Most well-liked and Earnings Securities Fund has leveraged belongings comprising 39.08% of its portfolio. This represents a major enchancment over the 41.43% leverage ratio that this fund had the final time that we mentioned it. The discount in leverage is sensible because the fund’s web asset worth is up by 8.63% for the reason that final article on this fund was revealed:

As I’ve identified in earlier articles when a fund’s leverage stays steady however the fund’s web asset worth will increase, the leverage ratio goes down. This is sensible as a result of the borrowed cash shall be a smaller share of the portfolio’s whole belongings.

As talked about within the introduction although, this fund is extra leveraged than we actually wish to see, and this has prompted issues for it in recent times. Specifically, the leverage amplified the fund’s losses when the Federal Reserve began elevating rates of interest in 2022 and these losses compelled it to chop its distribution a number of instances. That is the largest cause why the yield of this fund (and Flaherty & Crumrine’s different most popular inventory funds) is a lot decrease than its friends from different fund managers.

As already talked about, the fund may very simply hand over a few of its current beneficial properties if the Federal Reserve fails to satisfy the market’s expectations relating to rates of interest as appears doubtless. The excessive leverage will amplify these losses, so the chance appears fairly excessive right here. This supplies but one more reason why traders within the fund could wish to contemplate taking a few of their current beneficial properties.

Distribution Evaluation

As talked about earlier on this article, the first goal of the Flaherty & Crumrine Most well-liked and Earnings Securities Fund is to offer its traders with a really excessive stage of present earnings. In pursuance of this goal, the fund invests its belongings in a portfolio that primarily consists of most popular inventory. The defining attribute of most popular inventory is that it delivers nearly all of its whole funding returns within the type of direct funds to its homeowners. On this case, that’s the fund that collects all of those funds on behalf of its shareholders. The fund then borrows cash to buy extra securities and thus generates a better stage of earnings than it may with solely its personal fairness capital. The fund combines all of those funds with any capital beneficial properties that it manages to appreciate by buying and selling the popular shares in its portfolio after which paying them out to its shareholders, web of its personal bills. We’d anticipate that this enterprise mannequin would end result within the fund’s shares boasting a really excessive yield.

There’s a certain quantity of reality to this because the fund at present pays a month-to-month distribution of $0.0838 per share ($1.0056 per share yearly), which supplies it a 6.75% yield on the present worth. As talked about within the introduction, this isn’t a very spectacular yield for a most popular stock-focused closed-end fund, however it’s nonetheless fairly excessive in comparison with most home widespread shares that commerce available in the market. Sadly, this fund has not been notably in line with respect to its distribution. As we are able to see right here, the fund has each raised and lowered its distribution quite a few instances over its historical past:

One factor that we instantly see right here is that the fund needed to minimize its distributions quite a few instances ever since 2022. It’s hardly alone on this as most funds that spend money on fixed-rate securities needed to minimize their distributions because of losses suffered when rates of interest went up. This fund’s cuts had been maybe extra extreme than most, due a minimum of partially to its excessive stage of leverage. The fund did enhance its distribution starting in February 2024, however it nonetheless appears doubtless that its current historical past shall be a little bit of a turn-off for any investor who’s looking for to earn a protected and safe earnings from the belongings of their portfolios. It is a class that would come with many retirees and others who rely upon their portfolios to offer the earnings that they should help their life.

As simply acknowledged, the Flaherty & Crumrine Most well-liked and Earnings Securities Fund did simply enhance its distribution. There could also be some readers who take that as a constructive signal going ahead. Whereas which may be true, it isn’t essentially the case. In spite of everything, a closed-end fund can technically pay out greater than it truly earns from its investments and there are even a handful of funds that do that intentionally. For instance, the Cornerstone funds had been pretty infamous for consistently paying out distributions in extra of their earnings and conducting frequent share points to cowl the distinction. Thus, we should always nonetheless examine the fund’s monetary efficiency as a way to decide how effectively the fund is definitely masking its distribution.

Happily, now we have a really current doc accessible that we are able to seek the advice of for the needs of our evaluation. As of the time of writing, the fund’s most up-to-date monetary report (linked earlier on this article) corresponds to the full-year interval that ended on November 30, 2023. It is a a lot newer report than the one which we had accessible to us the final time that we mentioned this fund. That could be very good to see as a result of so much occurred through the six-month interval between Could 2023 (the time limit of the semi-annual report) and November 2023. Specifically, the summer time was reasonably brutal for closed-end funds like this one because the market started to just accept that high-interest charges could possibly be a fixture of the American economic system for an prolonged interval. This report will give us a good suggestion of the dimensions of the losses that the fund suffered in that setting. We will even get a little bit of an thought of how effectively the fund was capable of make the most of the market power on the finish of the yr, though it should nonetheless not embrace the month of December.

Through the full-year interval, the Flaherty & Crumrine Most well-liked and Earnings Securities Fund obtained $32,289,095 in dividends and $52,974,297 in curiosity from the investments in its portfolio. Once we mix this with a small quantity of earnings from different sources, we see that the fund had a complete funding earnings of $85,516,227 over the yr. It paid its bills out of this quantity, which left it with $48,991,318 accessible to the shareholders. This was, sadly, not sufficient to cowl the $51,340,909 that the fund paid out in distributions, however it did handle to get fairly shut. At first look, although, there should be a cause to be involved as we ordinarily would like {that a} fixed-income fund absolutely cowl its distributions out of web funding earnings.

Nonetheless, there are different strategies by means of which a fund can get hold of the cash that it must cowl the distribution. For instance, it would have the ability to earn some capital beneficial properties by profiting from the market pricing actions that accompany actions in rates of interest. Sadly, the fund failed miserably at this process over the full-year interval. It reported web realized losses of $37,402,047 and had one other $4,864,081 in web unrealized losses. Total, the fund’s web belongings declined by $43,164,142 over the full-year interval after accounting for all inflows and outflows. The fund clearly didn’t cowl its distribution for the second yr in a row:

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That is actually disturbing, and the fund could once more battle to cowl its newly raised distribution if the Federal Reserve does certainly disappoint the market and causes the value of fixed-income belongings to say no over the approaching months.

Valuation

As of January 30, 2024 (the newest date for which information is accessible as of the time of writing), the Flaherty & Crumrine Most well-liked & Earnings Securities Fund has a web asset worth of $16.24 per share however the shares at present commerce for $14.50 every. This provides the fund’s shares a ten.71% low cost on web asset worth on the present worth. That is costlier than the 12.08% low cost that the shares have had on common over the previous month, however it’s nonetheless a double-digit low cost.

The smaller-than-average low cost may characterize an excellent place to take some earnings off the desk. I’ll admit that I’m hesitant to counsel promoting a fund that’s nonetheless buying and selling at a double-digit low cost on web asset worth, however it may be a good suggestion given the dangers of a near-term decline within the share worth.

Conclusion

In conclusion, the Flaherty & Crumrine Most well-liked and Earnings Securities Fund is a reasonably in style closed-end fund that has been punished for taking over a considerable amount of leverage in previous years. The fund’s yield and whole returns are decrease than a number of the fund’s friends and this implies that traders who want to have publicity to most popular securities could also be higher off elsewhere. With that mentioned, all most popular inventory funds seem like overvalued proper now for the reason that market is pricing in a impossible trajectory with respect to rates of interest in 2024. As such, it may be a good suggestion to take some earnings proper now and cut back your publicity to a possible market correction.