We Love Preferred Stocks of Closed End Funds (CEFs)

At the risk of sounding like a broken record we will once again mention the comfort that owning preferred stocks of closed end funds can bring an investor. We say that IN RESPECT TO DIVIDEND SAFETY. There is a time to own these and with rising interest rates this may not be the time UNLESS you are simply looking for a super safe income stream of 5-6%.

While business development companies (BDC’s) are technically closed end funds, we are NOT including them in the discussion in this article. We are discussing closed end funds which hold equity positions or in some cases debt issues–assets which can be readily valued (Level 1). BDC’s typically hold Level 2 or Level 3 assets which are NOT readily valued meaning you have to just “trust” management to value their assets—this is why most BDC’s are not rated investment grade.

Closed end funds with preferred stocks are almost all issued by the Gabelli family of funds. This includes Ellsworth Growth and Income (NYSE:ECF) and Bancroft Funds (NYSE:BCV), both of which are managed by Gabelli. Including Bancroft and Ellsworth the Gabelli group has 12 funds that have issued preferred stocks.

In addition to the Gabelli family, General American Investors (NYSE:GAM), Kayne Anderson MLP Fund  (NYSE:KYN), Tri-Continental Fund (NYSE:TY) and RiverNorth Marketplace have outstanding exchange traded preferred stock issues.

Of all the above named issues we would be extremely comfortable holding all except RiverNorth Marketplace and the Gabelli Go Anywhere Puttable Preferred if we were looking for a solid, safe income stream.

RiverNorth Marketplace holds loans which are made through peer-to-peer lending sites and our personal experience with these sites (in particular Prosper) is not that favorable. Additionally RiverNorth Marketplace is not a publicly traded security and we are not buying preferred shares of any company that doesn’t have a publicly traded security which provides more transparency into company financials. The Gabelli Go Anywhere shares may be ok, but we simply have not studied the issue closely enough to feel comfortable buying puttable shares.

Note that the RiverNorth Marketplace issue is a Term Preferred as is the Kayne Anderson MLP preferred, thus they have date certain redemption dates.

Almost all of the above securities are rated solidly investment grade.  A couple issues are not rated, but the Tri-Continental issue (NYSE:TY-) is certainly equivalent to investment grade (the CEF has been around since 1929).

For those who are rather new to investing in CEF preferreds we must explain further why we are so comfortable owning preferred of CEFs for a solid income stream.    CEFs are controlled by something called The Investment Company Act of 1940 and in particular Section 18 of that deals with leverage provided by the issuance of senior securities.  Section 18 requires that a closed end fund maintain asset coverage of between 200% and 300% depending upon whether the senior securities are debt or preferred stock.  This shifts almost all of the risk onto the holder of the closed end fund common shares.  The senior security holders have the protection of the full asset base and with asset coverage ratios of at least 200 or 300% their is very, very little risk for the senior security holder.

If there were a severe stock market crash the CEF would either have to buy in some preferred shares if they were to violate the leverage rules OR more normally would have to sell more shares of the closed end fund until the company was back in leverage compliance.  Back in 2008-2009 this did in fact almost happen and a number of the Gabelli Funds sold huge quantities of common shares to ensure they did not violate the rules.  When the CEF is a fund paying a sizable dividend the last thing you want to happen is to violate the leverage rules as you would then be required to stop paying dividends on the fund.  For instance the Gabelli Utility Trust (NYSE:GUT) pays a 8.45% dividend and you can be certain there would be a bunch of po’ed security holders if this dividend was suspended.

We have put together a small page of preferreds offered by these closed end funds and it can be found here.

CAUTION–as with most high quality low coupon issues the share price is highly likely to decline if interest rates continue to go higher.  Buyers of these issues should generally be most concerned with safety and a steady income stream with the understanding that share prices will decline somewhat in the months (or years ahead) if interest rates rise.  Here you can get a look at a chart of the Gabelli Utility Trust 5.625% preferred that became redeemable in 2008 which shows the movement of share prices as interest rates rose–use your mouse to expand the chart to a longer time frame.

Additionally like all preferreds with a possibility of redemption one should probably purchase only those trading around $25/share and shy away from shares of those trading much higher than $25.25/share to avoid potential capital losses if shares are called for redemption.  Many of these issues are past their 1st redemption date so could potentially be redeemed at any time.

For those looking for a little “lite” reading the Investment Company Act of 1940 (which includes Section 18) can be found here.

Disclosure–we own a modest position in Tri-Continental preferred and a large position in the Kayne Anderson MLP fund term preferred.