A Preferred Way to Play Preferreds

12/12/2019 5:00 am EST

Focus: STRATEGIES

Michael Foster

Editor, BNK Invest

If you're not familiar with preferreds, they're a hybrid of bonds and stocks. They can trade on an exchange, just like any common stock, but they trade around a par value and dole out a set regular payment, like a bond. Financial companies are the main issuers of preferreds, explains income expert Michael Foster, editor of Contrarian Outlook.

With the 6.6%-yielding First Trust Intermediate Duration Preferred & Income Fund (FPF) you'll get access to a portfolio of preferred shares and bonds that consistently crushes the index.

Preferreds are less protected from a fall in corporate profits than corporate bonds, which means their prices can experience significant swings in times of market fear. FPF manages that risk by limiting duration to the shorter end of the intermediate range: the portfolio's current duration is 3.55 years.

Furthermore, FPF's portfolio volatility has been limited: the variance (0.56) in its NAV is low relative to similar funds, which means that its NAV doesn't crash so hard that leverage is a serious risk.

The fund's dividend-coverage ratio at 103.9%, the highest it's been for this long in nearly a decade. That average alone (plus further upside in the fund's portfolio, thanks to lower rates) is high and steady enough for us to say that FPF's days of distribution cuts are likely a thing of the past.

In short, there is a time delay between when rate cuts start happening and preferred-stock funds see their net income rising. We're now at the lowest point, where FPF's net interest income has fully priced in the rate hikes of the late 2010s. So looking forward, we're in a position to begin seeing rising net interest income as rates continue to get cut.

Total fees (including interest expenses) come to 2.49% for FPF, which is just a bit below the 2.68% average for all preferred-stock CEFs. While this sounds very high to CEF newbies, remember that it's taken out of the portfolio before returns and dividends are calculated.

Thanks to FPF's conservative and savvy investment style, it has crushed the index, and its managers have more than earned their keep. And that makes FPF a keeper.

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