Preferred Stock CEF: A Comprehensive Guide

Preferred stock CEFs, also known as closed-end funds, are a type of investment that can provide a unique combination of income and potential for long-term growth.

They are traded on major stock exchanges, such as the New York Stock Exchange (NYSE) and the NASDAQ, and are typically listed under the ticker symbol of the fund.

Investors can buy and sell shares of preferred stock CEFs through a brokerage account, just like stocks.

Preferred stock CEFs are required to distribute at least 90% of their investment company taxable income to shareholders annually.

CEF stands for Closed-End Fund, which is a type of investment vehicle that pools money from many investors to purchase a portfolio of securities.

A Closed-End Fund is a mutual fund that has a fixed number of shares outstanding, unlike open-end funds that issue new shares as needed.

These funds are managed by a professional investment team and are listed on a stock exchange, allowing investors to buy and sell shares like individual stocks.

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CEF shares are traded on an exchange, which can result in a price that is different from the net asset value of the fund's underlying securities.

The net asset value (NAV) of a CEF is the total value of its assets minus liabilities, divided by the number of outstanding shares.

CEF shares can be bought and sold at a price that is determined by market forces, which may be higher or lower than the NAV.

This can create the potential for investors to buy or sell shares at a discount or premium to the fund's underlying value.

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Preferred stock CEFs offer a unique investment opportunity that can benefit investors in the current market environment. The Fund seeks current income and, secondarily, capital appreciation through a portfolio of preferred securities issued by U.S. companies with market capitalizations of over $100 million.

Investors can expect a relatively stable income stream from these securities, which are typically less volatile than common stock. The Fund's focus on U.S. preferred stock and REIT preferreds provides a diversified portfolio with a mix of asset classes.

Jay D. Hatfield, the CIO and Portfolio Manager of Infrastructure Capital Advisors, explains that U.S. preferred stock and REIT preferreds can benefit investors due to their attractive yields and relatively low risk.

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Preferred shares are a form of structural leverage that allow a CEF to raise additional capital, which it can use to purchase more securities for its portfolio.

Preferred shares differ from common shares in three key ways: they typically pay fixed dividends, have priority to income and assets in the event of liquidation, and do not participate in the gains and losses on the fund's investments.

Mandatory redeemable preferred shares have a stated liquidation value that the fund sponsor is required to redeem for cash or other assets at the stated maturity date.

Here are the main types of CEF preferred shares:

CEF shares are a type of investment that allows a Closed-End Fund (CEF) to raise additional capital, which it can use to purchase more securities for its portfolio. This is done through the issuance of preferred shares.

Preferred shares are a form of structural leverage that allow a CEF to raise capital. They differ from common shares in three key ways.

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Preferred shareholders typically receive fixed dividend payments for a specified period. This provides a predictable income stream for investors.

In the event of liquidation, preferred shareholders have priority to both income and assets of the fund. This means they are paid out first, before common shareholders.

Preferred shareholders do not participate in the gains or losses on the fund's investments, as common shareholders do. This makes them a relatively stable investment option.

Mandatory redeemable preferred shares are a type of CEF share that pays dividends that may be fixed or variable. They also have a stated liquidation value that the fund sponsor is required to redeem for cash or other assets at the stated maturity date.

At year-end 2023, floating mandatory redeemable preferred shares represented 16 percent of all traditional CEF preferred share assets, while fixed mandatory redeemable preferred shares represented 2 percent.

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Auction market preferred shares are a type of preferred share that pay dividends that vary over time. The dividend rates are set through auctions run by an independent auction agent.

Auction procedures are governed by a set of rules established by the CEF and its auction agent. This means that the dividend rates are determined by the market forces of supply and demand.

In the past, auction market preferred shares were a common type of preferred share, but they suffered a liquidity crisis in mid-February 2008. Since then, their dollar amount has declined.

Traditional CEFs have largely replaced auction market preferred shares with alternative forms of structural and portfolio leverage.

Preferred stock CEFs are subject to various regulatory requirements, including the Investment Company Act of 1940, which governs the structure and operations of investment companies.

The Securities and Exchange Commission (SEC) oversees the registration and reporting requirements for preferred stock CEFs.

In terms of governance, preferred stock CEFs typically have a board of directors that is responsible for overseeing the company's operations and making key decisions.

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Regulatory limits on a fund's use of leverage are in place to prevent excessive risk-taking. CEFs, for example, are subject to asset coverage requirements if they issue debt or preferred shares.

For each $1.00 of debt issued, a CEF must have $3.00 of assets immediately after issuance and at the time of dividend declarations. This is commonly referred to as 33 percent leverage.

BDCs have similar limits, but with a slightly more relaxed 2:1 debt-to-equity ratio. This means they can have up to $2.00 of debt for every $1.00 of equity.

These limits are in place to ensure that funds have enough assets to cover their liabilities and maintain a stable financial position.

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Preferred shareholders have the right to elect fund directors. Section 18 of the Investment Company Act specifically provides them with the exclusive right to elect two fund directors.

Preferred shareholders also vote together with common shareholders to elect the remaining fund directors. This is a crucial aspect of fund governance.

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If a fund does not pay dividends to preferred shareholders for two years, Section 18 gives them the right to elect a majority of the directors. This ensures that preferred shareholders' interests are represented.

Preferred shareholders continue to have the right to elect a majority of the directors until all dividends in arrears are paid. This provision is in place to protect the interests of preferred shareholders.

The Cohen & Steers Tax-Advantaged Preferred Securities and Income Fund (PTA) has a portfolio of around 240 preferreds, with a significant portion coming from the financial sector.

PTA's tax-advantaged focus is achieved by investing in preferreds that pay qualified dividends and by holding onto these investments for a longer period to lock in favorable long-term capital gains rates.

The fund has a high level of international exposure, with about 40% of its assets coming from outside the U.S.

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PTA's credit quality is a bit lower than some other preferred funds, with less than half of its assets being investment-grade.

The fund's managers have struggled to deliver returns, with a volatile and disappointing first three years.

Despite this, PTA has a high yield and trades at a 7% discount to NAV, which is decent compared to its five-year average discount.

PTA's focus on tax-advantaged income potential is centered on two main strategies: investing in preferreds that pay qualified dividends and holding onto these investments for a longer period to lock in favorable long-term capital gains rates.

Here are the key aspects of preferred securities, which are relevant to PTA's strategy:

CEF Funds and ETFs are a great way to invest in preferred stocks, offering a convenient and cost-effective option. They allow you to pool your resources with other investors to gain exposure to a diversified portfolio of preferred stocks.

One key benefit of CEFs is that they can be traded on major stock exchanges, making it easy to buy and sell shares. This liquidity can be a big advantage for investors who want to quickly sell their shares if needed.

CEF Funds and ETFs also offer a range of investment options, from actively managed funds to index funds that track a specific market index.

The Nuveen Preferred & Income Term Fund (JPI) is a straightforward preferred-stock play, but with a couple twists and turns. It typically invests at least 80% of assets in preferred stocks and other income-producing securities, with management sticking to preferreds and convertible securities.

Its portfolio is heavily reliant on the financial sector, with 80% of assets allocated to diversified and regional banks, insurance, capital markets, and financial services. Credit quality is unremarkable, but it's better than the iShares Preferred and Income Securities ETF (PFF).

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The Nuveen Preferred & Income Term Fund (JPI) uses a lot of leverage, with a current leverage of 37%, which is extremely high compared to other CEFs. It trades at a 6% discount to NAV, which is twice as deep as its five-year average discount.

You can expect more short-term volatility with JPI due to its high leverage. This fund is also a term fund that will liquidate and distribute its net assets to shareholders on or before August 31, 2024.

The Cohen & Steers Limited Duration Preferred and Income Fund (LDP) is a little quirky, holding preferreds with shorter durations. It uses leverage to offer a 9% yield and trades at a 10% discount, which is 3x its historical rate.

This fund has historically outrun the benchmark and has a slightly better credit profile than the iShares Preferred ETF. However, it's also the youngest of the three funds and has been the worst-performing in its short publicly traded life.

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Virtus InfraCap U.S. ETF (PFFA) is an actively managed exchange-traded fund (ETF) that focuses on preferred stock investments.

Infrastructure Capital Advisors, LLC (ICA) is the registered investment advisor behind PFFA, and the firm was formed in 2012 in New York City.

ICA also manages a series of hedge funds in addition to the PFFA ETF.

The Virtus Infracap U.S. Preferred Stock ETF (PFFA) Prospectus from June 2024 is available for download or by email.

You can also download the PFFA SAI from February 2024, which provides additional information on the ETF's structure and operations.

PFFA is part of the ETFis Series Trust I, which has annual and semiannual financial statements available for download or by email.

Investors can also view the proxy voting record for ETFis Series Trust I.

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The SPDR ETF is a great option for those looking for a more stable investment in preferred stocks. It's a benchmark for preferred funds, including the Nuveen Preferred & Income Term Fund (JPI).

The iShares Preferred and Income Securities ETF (PFF) is a notable example, with a credit quality that is actually worse than JPI's - only about 55% of its preferreds are investment-grade.

The SPDR ETF is also a good choice for those who want to avoid the higher leverage of CEFs like JPI, which currently has a whopping 37% leverage.

Despite the volatility of the financial sector, preferred shares have historically had a lower volatility profile than common stocks.

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Preferred stock CEFs offer several benefits, including lower volatility than common stocks and credit-sensitive high yield bonds.

One key advantage is their ability to provide high income potential without taking on excessive volatility. According to historical data, preferred shares have a lower volatility profile than traditional US large caps and credit-sensitive high yield bonds.

Preferreds also compare favorably to dividend-paying stocks, investment-grade corporate bonds, and the broader bond market in terms of yield. In fact, a potential 6%+ yield for a group of primarily investment-grade securities is worth considering for the income generation portion of a portfolio.

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To achieve favorable after-tax returns, some preferred stock CEFs focus on investing in preferreds that pay qualified dividends and holding them for longer to take advantage of favorable long-term capital gains rates.

However, not all preferred stock CEFs are created equal. For example, the Cohen & Steers Tax-Advantaged Preferred Securities and Income Fund (PTA) has a high leverage of nearly 40% and a low credit quality, resulting in a volatile and disappointing performance over its first three years.

Preferred shares have low historical correlations to traditional stocks and bonds, indicating that their return patterns may be differentiated throughout certain market environments. This makes them a potential portfolio diversifier.

Here are some key characteristics of preferred stock CEFs: