Hurry Up and Wait for This High Yielder
What do you do when one of your favorite fund managers retires?
Do you throw in the towel?
Or do you give the new guys a chance to prove their mettle?
Savvy fund investors know that you follow the manager, not the fund.
In this case, however, the former fund managers are probably puttering around their houses waiting for their wives to send them on an errand.
At best, you might be able to follow them to the grocery store.
Of course, when that fund yields nearly 7.4%, as John Hancock Premium Dividend Fund (NYSE: PDT) does, these considerations may seem academic.
After all, rates may be rising, but they remain low by any reasonable standard.
And it will probably take a few more years before bond yields become competitive with a yield like the one that PDT typically has.
If you’re an income investor, you can’t afford to dismiss that kind of income stream just because the guys you trusted are now gone.
At the same time, it stands to reason that the guys who ran the fund since its inception should also be trusted to select the right successors.
To this end, PDT’s new managers, who have been running the show since the beginning of September, are seasoned investment professionals. Both have 20-plus years of industry experience.
For much of that time, they’ve been analysts. But most fund managers spent significant portions of their career as analysts before getting the opportunity to run money themselves.
And one of the two spent more than two years serving as co-manager alongside one of the original guys.
While I’d prefer a longer apprenticeship, that should be sufficient to learn the ropes and then some.
Not Like the Others
One of the things I’ve learned is that you can’t judge performance based upon short-term returns.
We’ve got less than five months of returns since PDT’s new managers took off their training wheels. That’s not enough time to reach any conclusions.
Further, there’s no single benchmark that’s an appropriate gauge of PDT’s performance.
The fund specializes in preferred stock, in general, and the utilities sector, in particular. But it’s not a pure-play on either.
Nearly 60% of PDT’s portfolio is currently allocated to preferreds, with most of the balance invested in utility stocks.
Preferreds are hybrid securities that have characteristics of both debt and equity.
Like bonds, preferreds generally pay fixed interest, though at a higher rate than a firm’s bonds to compensate for the risk of being lower in the capital structure.
Preferred shareholders get paid their dividends before common stockholders, hence the security’s name.
And if a company faces a cash crunch or even bankruptcy, preferred shareholders also come out ahead of those who own the common.
Like common stock, preferreds count as equity on a firm’s balance sheet. This attribute makes preferred issuance attractive during periods of uncertainty.
Some preferreds may even be convertible into shares of the common if certain conditions are met.
Utilities were prolific issuers of preferreds in the past. But they haven’t been issuing nearly as many in more recent years.
With interest rates at historic lows for so long, it’s been a lot cheaper for utilities to raise money by issuing debt. That could be changing.
To fill the gap left by utilities, PDT has been forced to load up on preferreds from the other sector that tends to issue a lot of them: financials.
Preferreds issued by the big banks account for roughly half of PDT’s allocation to this security.
So PDT’s unusual portfolio is split between the least risky sector—utilities (41.3% of assets)—and one of the most risky sectors—financials (32.8% of assets).
PDT has exposure to other sectors as well, though most are in areas that are typical of utility-oriented funds, such as pipelines and energy producers (12.1% of assets) and telecoms (5.0% of assets).
Given the portfolio’s unique mix of sectors and securities, it should be clear why it’s difficult to benchmark its performance.
Further complicating this analysis is the fact that, like many other closed-end funds, PDT uses leverage to enhance both its payout and returns.
The fund’s current leverage ratio is around 34%, which means that for every $1 of investable capital about $0.34 is derived from leverage.
Leverage can enhance performance during bullish periods, but takes a bite out of returns during bearish periods.
And it’s important to consider the risk that PDT borrows money to invest in rate-sensitive securities now that rates are rising.
Wait for the Discount
Despite the difficulties of measuring performance, let’s see how the new managers have done anyway.
Since the end of August, the fund’s net asset value (NAV) is essentially flat, slightly ahead of the S&P Preferred Stock Index’s decline of 0.4%.
That’s also well ahead of the Dow Jones Utility Average’s 7.5% drop.
But because closed-end funds like PDT have a fixed number of shares and trade on exchanges, their prices can deviate markedly from their NAV.
Although the fund’s NAV has mostly tread water during this period, its share price saw a huge jump during the final weeks of the year, then a sharp drop over the past two weeks.
At the end of December, PDT was trading at a huge 12.5% premium to the underlying value of its portfolio.
Even after the ensuing decline, the fund’s shares still command a 5.4% premium.
I won’t pay a premium to invest in a closed-end fund. It’s better to wait for a discount, which will also allow you to lock in a higher yield.
PDT has traded at an average discount of 3% over the past three years. That means it will trade at a discount again soon enough.
Waiting for a discount also confers another benefit: It gives us more time to judge the new managers.