FFC: Reliable Preferred Share CEF with Normalization Premium (NYSE: FFC)
The Flaherty & Crumrine Preferred and Income Securities Fund (FFC) is a closed-end fund with the investment objectives of high current income and preservation of capital. The vehicle invests its cash in a portfolio of preferred securities, mainly from the banking and insurance sectors. The fund’s asset manager is Flaherty & Crumrine, a leading preferred securities asset manager with an enviable track record. The CEF has very good total returns over 5 and 10 years which stand at 7.8% and 9.6% respectively. The fund has a long history, having been launched in 2003, and has been slightly accretive to net asset value over the past ten years. FFC exhibits a high Sharpe ratio of 0.64 (measured on a 5-year basis) and a fairly low standard deviation of 12.88. As described above, the fund focuses on bank and insurance preference shares with a profile that tends to overweight investment grade ratings (Baa ratings for 42% of the portfolio). While the historic rise in interest rates has not materially affected portfolio performance, we do see price declines at the start of each Fed tightening cycle. Like the Fed increase rates the underlying assets will continue to be under pressure, although to a much lower degree than traditional fixed income bonds. We are currently seeing the same price performance in FFC, with the fund having a negative year-to-date performance and a net asset value premium that has narrowed to almost zero. The fund also has a tax-advantage angle, with most 2021 distributions qualifying as qualified dividends. These types of dividends end up being taxed at the lower long-term capital gains tax rate. We like FFC and its historical risk/reward metrics, but anticipate further weakness from a pure price perspective, with flat or modest negative total return over the next six months due to the continued aggressive rate trajectory by the Fed. We rate FFC as Hold for the moment. A retail investor looking to deploy new capital into this fund is best placed to wait for another -5% selloff and the presence of a discount to NAV.
This section details some CEF metrics and overall fund analysis:
Leverage ratio: 33%
- The leverage is higher
Expense ratio: 1.82%
Manager: Flaherty & Crumrine
- Independent investment advisor controlled by its employees
- One of the oldest and most experienced firms specializing in the management of preferred securities
- Asset class average.
Discount/Z-Stat: 0.85% / -1.88
- The fund is currently trading at a premium.
Assets under management: $0.95 billion
- The fund has a high AUM for the asset class
The fund’s main holdings are made up of securities from major banks:
We can see that we have a bit of a focus on a few names (i.e. total net exposures greater than 3%), but these names are extremely large Tier 1 institutions outside of Energy Transfer LP.
Banks remain the fund’s preferred credits, as evidenced by the strong allocation to the sector. Bank balance sheets have strengthened during the pandemic and the credit outlook is very positive given rising interest rates. Insurance companies have also performed well, although insurer earnings continue to lag behind banks due to falling investment returns and rising catastrophe losses recently:
While the portfolio is oriented towards investment grade securities, the fund runs a very high credit risk:
Indeed, the fund’s credit profile gives us an idea of its historical performance – although not heavily impacted by a rising interest rate environment, the fund has experienced declines following events of widening credit spreads, as evidenced at the end of 2018.
The fund is down -3.5% from a total return perspective over the past year due to rising interest rates and a narrowing premium to net asset value:
Although most of the underlying securities are fixed-to-float, they still pay a very high spread over the floating rate even when converted:
This characteristic, together with the long expected maturity date of most securities, creates a long duration profile for the portfolio which results in interest rate sensitivity and net asset value depreciation when interest rates rise. interest increases.
The fund lost value during the early stages of the last Fed tightening cycle, but then recovered strongly:
We can see from the above that the fund lost value from a total return perspective in the early stages of the last Fed tightening cycle when the cut was announced, and subsequently when from the announcement of the first interest rate hike in 2015. This time around the cycle was much more compressed with some participants talking about a increase of 50 basis points in March 2022. This will result in significant pressure on the net asset value of the CEF in the first half of 2022.
Over the long term, the fund only suffers significant declines during notable credit events / periods of market risk aversion:
We can observe that the market sell-off at the end of 2018 and the Covid-induced sell-off were the worst suffered by the fund.
The fund has a very similar performance to its sister fund FLC:
We can observe that Flaherty & Crumrine’s smaller sister fund closely tracks overall performance over time.
Premium/Rebate to NAV
The fund tends to trade at a premium to net asset value for long periods of time:
In the chart above, the blue area represents periods when the fund was trading at a premium to its net asset value. It can be noticed that apart from 2018 and the other tightening cycle in 2013-2015, the fund has a propensity to have a market value higher than the net asset value. As we enter an aggressive tightening cycle, we believe this CEF will occasionally start trading at a discount to NAV, particularly due to risk aversion scenarios.
It should also be noted that the fund offers a tax-efficient ride thanks to its highly qualified dividend income distribution:
Coming from a boutique asset manager with significant experience in this niche sector, FFC is a solid and proven long-term investment. Its main risks are credit spread widenings and overvaluation due to net asset value premiums. The fund tends to weaken in the early innings of a Fed tightening cycle, a performance we are seeing right now. Properly set up as a long-term buy-and-hold vehicle, the FFC should be entered at an attractive time. We rate FFC as Hold for the moment. A retail investor looking to deploy new capital into this fund is best placed to wait for another -5% sell-off and the presence of a discount to net asset value.