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Monday February 15, 2010
Income expert prefers preferred fund
By Carla Pasternak, editor High-Yield Investing  Flaherty & Crumrine Preferred Income Fund (NYSE: PFD) is a closed-end fund that invests in preferred stocks from all over the world. At least three-quarters of the portfolio must be investment grade. I first flagged this fund in August 2009 at $8.24. Since then, the fund has paid $0.40 in distributions and the price has rocketed for a total return of +29% in just six months. PFD pays monthly distributions, which increased +14% to $0.072 per month since this past December. That gives the fund a solid 8% yield at today's price ($0.86/$10.23), even after the recent run up. For 2009, 100% of the distributions were from dividend income and 54% qualified for the reduced 15% tax rate. PFD generates such high distributions on a portfolio comprised of about 80% investment-grade preferred stocks (as of December 31, 2009) in part by leveraging about 30% of the assets. 
In other words, the fund borrows money at short-term rates to invest in higher-paying securities, thus earning money on the spread. For the year ended November 30, 2009, PFD generated $9.7 million in net investment income and paid out $8 million in distributions. This ample coverage provided room to raise its payout. The price of preferred stocks in general and the fund's net asset value (NAV), rebounded strongly as market panic from the financial crisis waned. Rising portfolio values have enabled the fund to borrow more money, as the fund's growing assets provide more collateral. In fact, of the +82.5% total return on NAV the fund generated in the year ending November 30, 2009, leverage added +32.8%. However, there's no free lunch. While leverage magnifies gains, it also magnifies losses, adding volatility to the share price.  As well, falling asset values in a down market increase the leverage as a percentage of the fund's assets. This may force the fund to pay down its debt by selling assets when prices are low, thus increasing losses. Also, rising short-term rates can squeeze profit margins, forcing the fund to cut distributions.Of course, none of these risks are currently an issue. According to the fund, preferred stock has benefited from the reduction in alternative investments over the past year. Also, the financial standing of banks -- which issue about 60% of preferred stock -- has improved, as evidenced by the repayment of TARP funds by many of the nation's largest banks. The distribution hike and steadily climbing share price has made an unbeatable combination for PFD investors. Even after the run up in price, PFD shares appear attractively valued. Shares currently sell at a -1.4% discount to NAV, while the five-year average has been a +3.2% premium. Action to Take --> Preferred shares may not see a similar run-up this year as they did in 2009. While total returns aren't likely to be as spectacular for PFD, the distribution appears solid, making the fund appealing for new money. Learn more about this financial newsletter at Carla Pasternal's High-Yield Investing. |
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