There are times that I make the assumption readers are aware of the various nuances of the preferred stock world, when in fact there are many newer readers of the website that are sometimes lost in the ‘banter’ that more seasoned investors toss about in the comments section–or that I do in a post I make.
With this in mind we should review why often we say that preferred stocks of CEFs (closed end funds) are the safest preferred stocks available to us income investors.
Closed End Funds are simply funds (mutual funds) that most often own shares of companies in particular market segments–for instance Gabelli Utility Fund (GUT) owns shares in public utility companies. CEFs are able to use leverage which open end mutual funds can not use. GUT uses leverage to attempt to increase their returns. Leverage is added money (either borrowed or preferred stock) used to increase investment purchases. The idea being that the investments will earn MORE than the cost of the leverage. Leverage is a wonderful thing when markets are rising–and tortuous when markets are falling.
Leverage by a closed end fund is considered a senior security–whether it is debt or a preferred stock it is senior to common shares of the fund.
As income investors we know that GUT has 2 outstanding preferred stock issues (GUT-A and GUT-C) with coupons of 5.625% and 5.375% respectively, which they use as leverage. They also have some Auction Rate Preferred outstanding as of 9/30/2018 which is not available to us individual investors.
As of 9/30/2018 GUT held $367 million in utility stocks and U.S. Treasury investments. GUT had $101 million in preferred stock outstanding (leverage). So the fund had a coverage of the ‘senior securities’ of over 300%.
From the Gabelli Utility Fund annual report effective 12/31/2017 you can see the funds coverage ratio over the years below–
So who regulates the leverage a company uses and why can’t a fund us massive leverage to try to ‘goose’ performance?
The Investment Act of 1940 (section 18) regulates the use of leverage by a closed end fund. I guess they anticipated the misuse of leverage by ‘gamblers’ and we are thankful for the law. In general it says that the CEF will have an asset coverage ratio of 200% immediately after a preferred stock offering. It also says that the CEF will have 300% coverage if the leverage used is debt. So for our example company above (GUT) they must have $2 of stock holdings for each $1 of preferred stock outstanding.
NOTE that while most business development companies (BDCs) are closed end funds they are covered by other segments of law and while covered by a less restrictive leverage law they are NOT nearly the quality of common stock CEFs.
Why are BDCs less safe than stock CEFs? Simply put the value of the holdings of a BDC are NOT observable–they are what we call ‘Level 3’ assets. BDC assets are mostly not publicly traded and thus you simply have to ‘trust’ the managers to let you know their opinion of value of the assets. Do you want all you investment eggs with these guys–just ‘trust me’? We do invest in BDC baby bonds and term preferreds, but believe me they are mostly a long way aways from investment grade.
On the other hand stock CEFs hold assets (shares of stocks or bonds) that we term ‘Level 1’–we can open our web browser and look on the stock exchange which will tell us what the individual stocks held by the fund are worth. It is highly unlikely that a ‘rogue’ manager can manipulate the fund when transparency is high.
Let’s look at an example of how this protects us, as owners of the senior securities.
In 2007 Gabelli Global Gold (GGN) had a coverage ratio of over 600%–after the market crashes in 2008-2009 the company had a coverage ratio of between 200-300% because their holdings had tumbled so far. If you are a manager of a closed end fund it literally scares you to death to go near the leverage cut-off. Why? A closed end fund is NOT allowed to pay distributions when they are break the leverage ‘rules’. If you are a closed end fund paying income to holders you sure the hell don’t want to have to suspend your distribution. So what do you do? You start selling new shares of common as fast as you can—and Gabelli did just that–over the next 3 years the company sold over $1 billion in common shares taking the coverage ratio to over 1,000%–now that is safety to a senior security holder.
As you can see most are rated A1, A2 or Aa3 by Fitch–with the AllianzGI issues being rated AAA. As we have said these are the safest preferred stocks available to retail investors like us.
While the coupons are always lower than other perpetual issues you are buying safety. Shares prices move down as interest rates rise–normal movement, but at the end of the day your shares are very safe (of course nothing in life is guaranteed).
We note that shares of Oxford Capital and Priority Income are NOT investment grade and while they are covered by the leverage rules their holdings are higher risk Collateralized Loan Obligations (CLOs).
The examples we use above are simplified examples and there really are more detailed rules that have to be followed. For instance regulations dictate what happens when leverage rules are broken–how much time is allowed to get back to compliance etc. We have not seen a CEF break the rules in the last 12 years–if it has happened we are not aware of it.