"Preferred" Profits

06/10/2005 12:00 am EST


Carla Pasternak

Editor, The Income Investor

"There are roughly two dozen closed-end funds that invest in a variety of investment-grade preferred stocks; these vehicles now offer some of the richest yields in the investing universe," notes income expert Carla Pasternak. For income investors, she offers her favorites.

"Closed-end funds trade like stocks, but also track a portfolio of stocks and bonds just like a mutual fund. One key distinction between open-end and closed-end funds is that the latter has more latitude to leverage its assets. In other words, some closed-end funds borrow money and then reinvest it in securities that generate higher returns than their borrowing costs. If the strategy works, shareholders receive even juicier payouts, since closed-end funds are required to distribute most of their winnings to shareholders. However, investors should approach these funds with eyes wide open. The strategy is not foolproof. In fact, the spread between short-term and longer-term rates has diminished considerably in recent years and several closed-end funds have cut their dividends.

"What characteristics should you look for in a well-managed fund? To begin, focus on funds that have leveraged no more than 35% of their asset base. They will be in a stronger position to withstand unfavorable interest rate moves. Next, you look for funds that have portfolios heavily weighted towards investment-grade holdings. Finally, place a greater vote of confidence in a fund that sets its dividend at a level that is attractive, but also sustainable over the long term. You may need to do some digging to find funds with these positive attributes, but the potential reward of investing in a well-managed closed-end fund is worth the effort. I've selected five as my favorites:

"Currently, you can lock in a 9.3% yield on Preferred Income Strategies Fund (PSY NYSE). Managed by investment firm Merrill Lynch, this fund has invested about 85% of its assets in investment-grade preferred stock, and the balance of the portfolio is in corporate bonds. The average credit rating of the fund's portfolio assets is low-level investment-grade Baa1. About 55% of the funds holdings are securities issued by banks, REITs, and insurance firms.

"John Hancock Preferred Income Fund III (HPS NYSE) offers a yield of 8.6%. This fund's unique selling point is that it invests in undervalued securities that have room to move. About 80% of its assets are devoted to preferred stocks, primarily issued by financial service and energy-related firms. About four-fifths of its securities are rated investment-grade BBB or better, including about 44% that are rated A or higher.

"Cohen & Steers REIT and Preferred Income Fund (RNP NYSE) offers a yield of 8.9%. As its name suggests, this fund draws the lion's share of its income from real estate investment trusts. It invests up to 60% of its portfolio in the common stock of REITs and places the balance in a diverse array of preferreds and debt securities. While at least 90% of its assets are investment grade, the portfolio does carry some below investment-grade debt, which helps boost the yield. About 60% of the fund's 166 holdings are securities issued by office, apartment, or healthcare REITs. Of all the funds I suggest here, RNP has delivered the best performance over the past year, with a solid +23% total return.

"Nuveen Preferred & Convertible Income Fund (JPC NYSE) is yielding 9.8%. Investors looking for a high-yielding, broadly diversified fund should find this fund fitting. Its latest quarterly report lists over 500 separate holdings spread across a wide array of industries, from thrifts to textiles. The fund is also unique in its focus on convertible securities, which along with preferreds, constitute at least 80% of its portfolio. Its superior yield carries a bit more than the typical risk, considering that just 65% of its assets are required to be investment grade.

"Flaherty & Crumrine/Claymore Preferred Securities Income Fund (FFC NYSE) yields a head-turning 9.8%. It is a true-blue, closed-end preferred share fund. At least 80% of its portfolio holdings consist of preferred stock. Nearly half of the preferreds are issued by banks and financial institutions. Insurers, utilities, and an assortment of other groups account for the balance. Most of the fund's preferreds are ‘hybrid’ or taxable preferreds, so the after-tax yield should be roughly equivalent to the other funds listed above. About 90% of its assets are rated Baa or better, including over one-third that are rated A."

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