Co-produced with Beyond Saving
We first wrote about Virtus InfraCap U.S. Preferred Stock ETF (PFFA) in early August. At High Dividend Opportunities, we tend to be biased toward closed-end funds (or CEFs) as opposed to exchange-traded funds (or ETFs). The reason being that CEFs are actively managed, which with a good management team can materially improve returns.
Unlike the vast majority of ETFs which passively track indexes, PFFA is a managed ETF. This means that the managers are making decisions day to day on which stocks to buy and which to sell.
What attracted us to PFFA is that while many preferred share funds and ETFs have a lot of exposure to issues already trading at or even above par, PFFA focuses on opportunities that are trading at a discount. They also actively sell off preferred shares when their yield-to-call becomes unfavorable. As a result, they have a lot of exposure to preferred picks that we also are recommending. If we were to create an ETF, it would look a lot like PFFA.
The managers also use 20% to 30% leverage to boost income. Due to their opportunistic approach, this ETF currently yields 9.2%. PFFA is currently out-earning its dividend and has upside as many of its holdings still trade at a discount to par. A high yield that’s sustainable, combined with potential for capital appreciation, makes PFFA a great opportunity.
PFFA has more than 150 holdings, though since the world of preferred shares is relatively small, they do have larger concentrations in some.
Their largest holding is American Finance Trust 7.5% Preferred A (AFINP), a preferred we have written about several times in the past. This preferred is backed up by an impressive triple-net lease real estate portfolio.
RLJ Lodging Trust, Series A Cumulative Preferred (RLJ.PA) has been one of our favorite preferred picks to load up on after the COVID-19 crash. RLJ Lodging Trust (RLJ) has a very strong balance sheet, and unlike most preferred shares, RLJ-A is not callable, so its price upside is not limited by par value.
There are several other preferred shares in the top 10 that we hold in the High Dividend Opportunities Preferred Stock Portfolio. The general theme of these picks is that they are trading under par value, they have higher than average yields, yet they have sound balance sheets.
As we look through the rest of PFFA’s holdings (Excel download), there are several other holdings that we are very bullish on. The listing also includes a few baby bonds (even though they’re listed as preferred shares).
High Upside Potential, Controlled Downside
When preferred shares sell off below par, we love taking advantage and buying. Especially with interest rates so low, yields from preferred shares become more valuable. So being able to invest below par in an environment like this provides for strong bias to the upside.
Meanwhile, downside risk is controlled by preferred shares seniority over common shares. The common shares cannot receive any dividend until the preferreds are paid in full.
The real threat to preferred shares is that they tend to have poor recoveries in bankruptcies since they are junior to all debt. So when prices dropped across the board, not necessarily associated with any real bankruptcy risk, it was a buying opportunity with substantial upside and unlikely further downside. This is exactly what happened back in March 2020, and PFFA was able to bank on this opportunity.
In Q3, PFFA saw this dynamic play out.
Several of PFFA’s picks had solid upside in the quarter. Nobody is perfect and PFFA had one holding that had a significant negative contribution to the fund. Ashford Hospitality Trust (AHT) is a hotel REIT that’s struggling and recently attempted to offer common shares in exchange for preferred shares. An offer that has not yet gained acceptance from the majority of preferred shareholders.
There’s no question about it, the outlook for AHT is dismal. This is where PFFA’s active management comes in. Most EFTs would continue to hold AHT and even buy more when new money came in to maintain the same weighting until the date that it no longer met the criteria to hold. PFFA stopped buying AHT preferred shares. So when shares were redeemed, AHT preferred shares were sold, and when new shares were bought, AHT preferred shares were not bought.
Through this attrition, PFFA’s holdings of AHT preferred shares has declined from 460k shares in July to 80k shares today. Leaving current shareholders with exposure to picks that have a much brighter future. The negative impact of AHT will fade, while Colony (CLNY), Braemar (BHR), and RLJ all have plenty of upside to go and are all positions that PFFA has been growing.
PFFA’s fee ratio is higher than typical for an ETF at 2.0%. This expense ratio is made up of two parts.
First, the management expense is at 0.8% of net assets. This is higher than usual for an ETF, but that is due to the active management discussed above. Infracap is putting time, effort and manpower behind determining which stocks to invest in, how to weight them, and when to sell. An ETF that is just tied to an index is going to have much lower fees because it is the quintessential “dumb money” that is buying according to a formula without thought.
At 0.8%, the management fee is in line with what we typically see with actively managed CEFs, like those managed by Cohen & Steers or PIMCO.
The remaining 1.2% in the expense ratio comes from the costs of leverage. PFFA uses leverage at 20%-30% of gross assets, which will help improve returns as their holdings go up and also improve the dividend. The expense will vary depending on variations in PFFA’s leverage and interest rates.
Since PFFA can access leverage at a much lower price than individual investors generally can, this is a benefit to buying PFFA as opposed to trying to reconstruct the same portfolio. Note that the expense fees are not subtracted from your dividend – those expenses are paid before the dividend is distributed. Therefore investors get the full yield of 9.2%.
We believe that the majority of PFFA’s holdings are on the road back the par value. From today’s prices, that means capital gains upside of approximately 20%. This impact of COVID-19 on businesses is becoming more clear and problems are being solved. As life moves on, the preferred shares will become more secure and pricing will improve throughout the year.
In the meantime, you can enjoy collecting monthly dividends.
When the COVID-19 crisis started, PFFA reduced their dividends due to the uncertainty and several preferred which have suspended their dividends, particularly in the mREIT sector. Today, those preferred shares have resumed their dividends.
With cash flow becoming more certain, we fully expect that in early 2021, PFFA will raise their dividend.
In late 2018/early 2019, we focused on building up our preferred share portfolio. We saw an opportunity to buy in at good prices and encouraged members to allocate 35%-50% of their portfolios to fixed income. With the uncertainty that COVID-19 brought in 2020, the reliability of income from our preferred portfolio shined.
Building a preferred portfolio takes time, PFFA is an option for those looking to quickly increase their preferred exposure. This ETF took on an investment philosophy that’s very similar to ours, buying preferred stocks that are trading at a discount to par. This results in high-yield and upside opportunity when the shares return to par.
The bottom line is that in the next year we see price upside of approximately 20%, plus a dividend that currently yields 9.2% – a dividend that’s likely to be increased in early 2021. We would be willing to buy for just the cash flow alone. PFFA deserves a place in any fixed-income portfolio, including conservative investors. The monthly pay feature is a big plus for those looking for a regular paycheck.
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Disclosure: I am/we are long PFFA, AFINP, RLJ.PA, CLNY.PI, AND CLNY.PJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities.