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Recent Performance
Preferred Securities
Dividends
Hedging and Leverage
Other Topics
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Recent
Performance |
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What
were the components of PFD's total return on net asset value for the year
ended November 30, 2007? (Annual Report 11/30/07)
While we realize it's only small consolation, as set forth in the table below, PFD's total return on its securities portfolio was better than these indices. Unfortunately, as one might expect, PFD's strategy of using leverage amplified its negative returns and, coupled with its expenses and hedging strategy, caused the NAV of PFD to perform worse than two of the indices. The
table below reflects the performance of each investment tool used by PFD
to achieve its objective, namely: (a) investing in a portfolio of securities;
(b) hedging that portfolio of securities against significant increases
in long-term interest rates; and (c) issuing an auction-rate preferred
stock to leverage and enhance returns to Common Stock shareholders. The
table then adjusts for the impact of PFD's expenses to arrive at a total
return on NAV (which factors in all of these items).
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What
were the components of PFO's total return on net asset value for the year
ended November 30, 2007? (Annual Report 11/30/07)
While we realize it's only small consolation, as set forth in the table below, PFO's total return on its securities portfolio was better than these indices. Unfortunately, as one might expect, PFO's strategy of using leverage amplified its negative returns and, coupled with its expenses and hedging strategy, caused the NAV of PFO to perform worse than two of the indices. The
table below reflects the performance of each investment tool used by PFO
to achieve its objective, namely: (a) investing in a portfolio of securities;
(b) hedging that portfolio of securities against significant increases
in long-term interest rates; and (c) issuing an auction-rate preferred
stock to leverage and enhance returns to Common Stock shareholders. The
table then adjusts for the impact of PFO's expenses to arrive at a total
return on NAV (which factors in all of these items).
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Preferred
Securities and Hedging Strategy |
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What
are enhanced preferred securities? The change that prompted the emergence of enhanced preferred securities was the adoption in February 2005 by Moody's Investors Service of a revised methodology for preferred and hybrid preferred securities which granted an issuer varying degrees of equity credit, ranging from 0% to 100%, depending upon the terms of the issue. Just prior to that time, Moody's generally gave no equity credit for hybrid preferred securities, no matter what features they contained, and limited equity credit for traditional perpetual preferred securities. Because other rating agencies already gave issuers some equity credit for preferred securities, Moody's action relieved a critical constraint upon the financing decisions of issuers, and thus on the preferred securities market in general. It
has taken Wall Street bankers time to obtain tax opinions, master the
accounting and line up issuers, and structures have continued to evolve
- each seeking the right combination of terms for the market, the rating
agencies and the regulators. While structures have begun to converge into
more standardized forms, there has been a good deal of experimentation,
and the past year has produced a number of unique structures. We view
this as good news for the Funds' shareholders and we have actively traded
in these new structures. The heterogeneity of preferred securities is
why we invest in them. Enhanced preferred securities, in all their various
permutations, simply add to the complexity and allow managers who specialize
in this market to excel. What
are the key features of enhanced hybrid preferred securities? Under Moody's methodology, Moody's ranks a preferred security's terms along three dimensions - No Ongoing Payments, No Maturity, and Loss Absorption - assigning a designation of none, weak, moderate, or strong to each dimension. The designation "none" indicates that the security is most debt-like, while "strong" indicates it is most equity-like in that dimension. Depending upon the rankings across the three dimensions and the rating of the issuer, Moody's places the security into one of five baskets with varying amounts of equity credit from 0% to 100%. On the No Maturity dimension, issue maturity is always at least 30-years and generally 50- to 60-years (or perpetual) - in general, the longer the maturity the stronger the ranking. In addition, issues need some form of replacement language, either in the form of an explicit promise to replace the issue with a security at least as junior as the one it replaces ("mandatory" replacement) or in the form of an intent-based replacement statement; not surprisingly, mandatory replacement language results in a stronger ranking. For a non-perpetual issue, the No Maturity ranking amortizes as the maturity date approaches. The amortization points vary depending upon the form of replacement language, with mandatory replacement language issues amortizing later than intent-based ones. On the No Ongoing Payments dimension, issuers have four main variables with which to work. First, a long deferral period (typically 10- to 12-years) is the norm for stronger equity credit issues. Second, deferral can be either optional or mandatory, with mandatory deferrals receiving a stronger ranking. Third, payments can be cumulative or noncumulative, with the latter providing stronger ranking. Finally, the issuer may include an "alternative payment mechanism" for making interest or dividend payments with the proceeds of common or (subordinated) perpetual preferred stock issuance. On the Loss Absorption dimension, the key term is the level of subordination. All issues are subordinated to senior debt and subordinated debt, but they vary beyond that. Moving down the capital structure from trust preferreds to perpetual preferred stock to common stock, enhanced preferreds are always senior to common stock, but some are equal in seniority to perpetual preferred stock and junior to trust preferreds, while others are senior to perpetual preferred stock and junior to trust preferreds (this is where most issues fall), while still others are senior to perpetual preferred stock and equal in seniority to trust preferreds. Moody's assigns a stronger ranking for Loss Absorption to issues with greater subordination. Issuers
and their bankers work through the various alternatives, comparing their
costs in the market with the level (and longevity) of equity credit achieved,
to arrive at the lowest-cost financing that achieves the issuer's objectives.
Most issuers have opted for terms that result in 50% to 75% equity credit
treatment. While the features needed to achieve the higher equity treatment
typically add to the cost of the issue, compared to the cost of issuing
a combination of debt and common stock, an enhanced hybrid preferred is
very cheap financing. It's no surprise, then, that the market has seen
such rapid growth. What
are the differences between traditional preferreds and hybrid preferreds? Hybrid
preferreds were created in the mid-1990s for the purpose of allowing issuers
to get a deduction for the dividend payments on preferreds, just like
they deduct interest payments on debt securities. Since no tax is paid
by the issuer, there is no double tax to avoid and no DRD available to
a corporate holder of hybrids. Initially, hybrids were primarily purchased
by individual investors, but the market has now broadened to include institutions
as well. The distributions from hybrid securities are classified as interest,
and as such, they are taxed as ordinary income to the individual investor.
Please contact your tax advisor for further discussion on this matter. |
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Are
there any federal tax advantages to the distributions made by the Funds
in 2007? For detailed information about the tax treatment of the particular distributions received from the Funds, please see the Form 1099 you receive from either Fund or your broker. Corporate shareholders also receive a federal tax benefit from the 59.0 of PFD's distributions and 60.6% of PFO's distributions that were eligible for the inter-corporate dividends received deduction or DRD. It
is important to remember the composition of the portfolio and the income
distributions can change from one year to the next, and the QDI or DRD
portions of next year's distributions may not be the same (or even similar)
to this year's. How
does each Fund report the breakdown between dividends and interest? How
does each Fund produce income? How
does leverage impact the amount of the dividend? Does
the hedging strategy impact the amount of the dividend?
The mechanism is pretty straightforward - if long-terms rates rise significantly, the instruments used to hedge the portfolio should increase in value. This increase offsets some of the decline in the value of the Fund's investment portfolio (protecting the Fund's NAV) and produces gains which can be used by the Fund to purchase additional income-producing securities. There is an expense associated with hedging, however. We like to use the analogy of an insurance policy - each Fund pays premiums (cost of the hedging instrument) to buy "insurance," and it collects on the policy if long-term interest rates rise significantly. If rates do not rise significantly, then the Fund will lose the premium it paid without receiving any benefit. Like most insurance policies, it is better to have the insurance and not need it than to need it and not have it. In
addition, the rate of the "insurance premium" is a function
of many things, but a key factor is the differential between short- and
long-term interest rates. As a general rule, when this differential is
large, the cost of hedging is high. How
does each Fund balance the factors that affect the dividend? Having said that, we can make some general observations about how the legs of the stool relate to one another. We already noted that falling long-term interest rates and rising short-term interest rates tend to lower income. At the same time, a flatter yield curve (i.e. a smaller difference between long and short rates) lowers the cost of hedging, potentially improving returns going forward. Conversely, rising long-term and short-term interest rates tend to increase income and, at the same time, increase the cost of each Fund's leverage. Whether the cost of hedging changes depends on how long-term and short-term interest rates move relative to each other. Although far from perfect, over the longer term there is some degree of balance among the three legs of the stool. Nonetheless,
over the shorter term, interest rate changes can adversely or positively
impact the income a Fund receives and the cost of its leverage and hedging,
and shareholders should consider these changes and their impact on the
net income generated by that Fund and consequently the size of the dividend
it is able to pay. Can
I reinvest dividends directly into the Funds and is there any benefit
over purchasing shares in the open market? How
do changes in interest rates affect each Fund's income?
The top line (measured on the left-hand scale) in the graph represents the monthly dollar income received from an original investment in 1,000 shares of each Fund. In comparison, the yields of long-term U.S. Treasury bonds are shown by the bottom line (measured on the right-hand scale). The graph assumes that the shareholder spent his or her regular monthly income from the Fund and reinvested at net asset value just the portion of each special year-end distribution that was "above and beyond" the monthly dividends. This
does not mean the monthly dividend distribution will not fluctuate. We
attempt to set a sustainable monthly distribution, but there are factors
that affect the distributable income to the Funds, including the cost
of leverage. A lower interest rate on the leverage, relative to the rate
of return on the portfolio assets, will help produce more income to the
Funds than a higher rate. The change may cause the monthly distribution
to be increased or decreased. The Funds do not hedge against the change
in these short-term interest rates. However, distributions are not determined
solely by the cost of leverage. There are factors that may offset the
changing cost of leverage, including the cost of hedging the portfolio
against a significant rise in long-term interest rates. The changing cost
of hedging tends to offset the changing cost of leverage when the relationship
between short-term and long-term Treasury interest rates changes. However,
these costs affect the Funds differently. The cost of hedging impacts
the NAV's of the Funds, while the cost of leverage impacts distributable
income. The offset ties together at total return, but may affect the monthly
distribution or NAV of the Funds as market relationships change. What
does "Ex-Div"refer to? Why
am I receiving a written (or electronic) notice with my dividend payment?
Section 19 of the Investment Company Act of 1940 ("1940 Act") requires registered investment companies to include a notice with the payment of a dividend if a portion of that dividend may come from sources other than undistributed net income. The two other most common sources from which dividends could be paid include the net profits from the sale of securities (capital gains), and paid-in capital (non-taxable return of capital). The purpose of Section 19 is to afford security holders adequate disclosure of the sources from which dividend payments are made. The numbers included in such notices are only estimates, as the actual characterization of distributions is only determined on an annual basis. Such characterization is then reported to investors on Form 1099 DIV in January of each year. The report will also appear on this website here. A
Section 19 notice generally does not accompany every dividend payment,
and the need to send such notice is determined by each Fund individually.
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Hedging
and Leverage |
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How
does the slope of the yield curve impact the cost of the Funds' hedging
strategy? Second, an inverted yield curve would reduce the cost of hedging on 100% of the portfolio. That is because the long-term cost of hedging is directly affected by the slope of the yield curve. When the yield curve is steep - as it has been for most of the past four years - hedging tends to be expensive, because the market charges hedgers the difference between long- and short-term yields. If the yield curve inverts, however, hedgers earn the difference between short- and long-term yields. Third, how the yield curve inverts is also important to the Funds. On one hand, if the yield curve inverts with short-term rates rising and long-term rates falling, leverage costs rise while the hedge loses money. On the other hand, if the yield curve inverts with both short- and long-term rates rising, the hedge gains can be used to offset some portion of the higher leverage costs; how much depends upon how far and how quickly long-term rates increase. As
we have explained in the past, the first two effects tend to generally
offset each other over time in total return, with the higher cost of leverage
reducing income and the lower cost of hedging improving NAV. But how those
effects play out in any given quarter or year depends upon the third factor:
How rates actually move. What
are interest rate swaps and swaptions? At the risk of oversimplification, this is the essence of an interest rate swap between two parties. Party A makes a "loan" to Party B at an interest rate that is fixed for the life of the swap. Party B makes a "loan" to Party A for the identical amount and life at an interest rate that will be variable based on a market indicator of short-term interest rates, which is often LIBOR (the London Interbank Offer Rate). Since the amounts of the "loans" offset each other, the only cash that actually changes hands is the difference between the fixed and variable interest rates, which will fluctuate over the life of the swap as the variable interest rate changes. The structure of interest rate swaps, although it may seem somewhat contorted, makes them very useful in a wide range of hedging situations. The market value of existing interest rate swaps will reflect swings in general interest rates in a reasonably systematic way, which will, depending on how things turn out, be good for one of the parties to a swap and bad for the other. In this respect, swaps resemble each Fund's current hedges, but they also differ since they are not tied specifically to interest rates on Treasury bonds. At any point in time, they may or may not track preferred stocks closely given the often-observed idiosyncrasies of the preferred market. There
are various other risks of derivatives involved in interest rate swaps
and swaptions. Even though major financial and broker/dealer organizations
are the usual counterparties, anyone entering into such an agreement must
carefully consider the other party's credit worthiness and its ability
to perform its obligations. Market liquidity may also be a risk at certain
times. Furthermore, legal and operational risks may be a reason to avoid
more exotic derivative contracts. As is the case with each Fund's present
hedges, interest rate swaps and swaptions involve significant economic
leverage that could cause relatively small changes in interest rates to
produce disproportionally large swings in the market value of the swaps
or swaptions and a significant risk of loss. What
do swaptions add to each Fund's hedging strategy? How
does each Fund receive a benefit from its use of leverage when the U.S.
Treasury Yield Curve is flat or inverted? Fundamentally, leverage is the use of borrowed funds to improve one's rate of return from an investment, although with an increase in risk. Each Fund acquires its additional funds through the issuance of Money Market Cumulative PreferredTM Stock (MMP®). Generally, the rate paid on the MMP® is well below the rate the Fund can earn on its total investment portfolio, and the rate the Fund pays on the MMP® is relatively low compared with other means of financing. This is particularly true because of the tax advantages to corporations and U.S. individual taxpayers of investing in MMP®. The additional cash flow generated by leverage produces additional income available for distribution to Common Stock Shareholders. The incremental income is greatest when the "spread" between the income generated by the portfolio and the rate paid on the MMP® is wide. However, the converse is also true; as the U.S Treasury yield curve "flattens" (short-term rates and long-term rates approach equality), the amount of additional income generated by the leverage will decrease. Each Fund still benefits from additional income generated by the leverage, just not as much as when the Treasury yield curve is steeper. Of course, nothing is that simple. Each Fund's income is determined by several factors, the cost of leverage being only one. In the case of a slightly inverted U.S. Treasury yield curve (short-term rates higher than long-term rates), each Fund should continue to benefit from the use of leverage. Preferred and debt securities generally trade at yields higher than the Treasury yields, commonly referred to as the "credit spread." So, although the Treasury curve may be inverted, the securities in the portfolio ordinarily will continue to have a higher return than the short-term rates the Fund pays for its leverage. If
the Federal Reserve maintains its current pause on short-term rates and
long-term rates do not decrease materially, each Fund's leverage should
continue to produce similar amounts of additional distributable income
to what it does now. If the Federal Reserve resumes raising short-term
rates, each Fund's leverage could produce lesser amounts of additional
distributable income. Of course, if the Fed lowers short-term interest
rates, each Fund should see a greater benefit from its use of leverage
and consequently have more additional distributable income for its Common
Stock Shareholders.
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What
are the fundamental credit trends of financial services companies (Annual
Report 11/30/07) Recognizing
these risks, we remain confident about the overall creditworthiness of
the Fund's holdings of financial issuers. Overall, we believe that the
issuers (a) are well capitalized, (b) have strong business franchises,
(c) are well managed, and (d) have access to additional capital, if needed.We
believe that they have the ability to absorb sizable losses and still
navigate a difficult credit landscape. Because most of these financial
companies operate in a mark-to-market environment, their write downs already
reflect both current and expected future losses. Although we admit that
we worry about a few holdings more than others, we believe that overall
credit quality of the portfolio remains sound. Put simply, we think that
current preferred securities prices more accurately reflect the fear and
illiquidity of today's credit markets than the fundamental creditworthiness
of the issuers. It may take some time, but we are confident that preferred
securities prices will reflect more of their creditworthiness eventually.
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How
can investors purchase shares of Common Stock of either Fund? Why
do the Funds trade at premiums or discounts to NAV? These benefits are accompanied by investment risks that do not exist with open-end funds. Open-end funds issue and redeem shares directly with their shareholders at a price equal to the underlying value of all fund assets (Net Asset Value or NAV). Closed-end fund shareholders do not have the right to cause the redemption of their shares. Instead, closed-end fund shareholders buy and sell their shares on markets like the New York Stock Exchange. A closed-end fund's shares should trade relative to the NAV of the fund - the market, however, further exposes the price of the shares to the laws of supply and demand and the price can and does vary widely from NAV. Supply and demand for a fund is dictated by each investor's perception of the underlying value of the shares relative to other available investment options. The starting point for any investor considering selling or purchasing shares of a fund is the NAV calculated by the fund. With income funds, like PFD and PFO, investors also consider the fund's dividend levels. These two performance components of NAV and income are reflected in the fund's total investment return on NAV. In fact, the best measure of the performance of an investment adviser is the fund's total investment return based on NAV. Like all investors, investors in closed-end funds make their own decisions about the fundamental quality of a fund's NAV and the likelihood that it will continue to produce similar total returns on NAV. An investor may value a fund's shares at a premium to NAV if the investor believes that the fund is likely to perform better than it has in the past, because of projected dividend levels, net asset value, net asset value volatility, call protection, quality of fund management and portfolio credit quality. Alternatively, an investor may similar value a fund's shares at a discount to NAV based on negative interpretations of the same factors. Investor decisions are never made in isolation, however, and supply and demand cannot be fully understood without reference to the market conditions for a fund's shares and the investor's objectives and alternative investment opportunities. In other words, an investor may decide to purchase or sell shares of a fund based on reasons unrelated to his or her assessment of the fund's total return on NAV. Commentators speculate that some investors apply an automatic discount to NAV because of the nature of the closed-end fund structure itself - yet some funds consistently trade at premiums. Once an investor has decided to purchase shares of a closed-end fund (perhaps because of some of their inherent advantages), comparative performance matters as well. Stated another way, a fixed-income investor will typically gravitate to that fund in a group of funds with similar investment objectives which offers the best yield for the amount of risk involved. Finally, investment decisions may be motivated for reasons beyond the performance of the fund, the closed-end structure, or comparative performance. Investors always have personal economic situations that impact their decisions. One example of this may be year-end tax selling. If an investor has losses in a closed-end fund, and gains in some other investment, that investor may make a rational decision to sell his or her shares of the fund at year-end in order to offset any tax gains. In a market environment, tax selling is especially detrimental because it can provide increased supply which may drive down the market price which can in turn lead to more tax selling. Of course, no single reason can explain the price calculated by a market. There are as many reasons, or combination of reasons, as there are shareholders for why each investor sells or buys shares. And, in the end, the collective effect of all these investor decisions may result in market prices at a premium or discount to NAV. PFD
and PFO are no different than any other closed-end funds, and their market
prices will be controlled by the laws of supply and demand.
What
are the differences between "closed-end funds" and "open-end
funds"? First, let's identify the similarities. In general terms, both types are built around professionally managed portfolios intended to meet a specific investment objective. At any point in time, the value of the portfolio can be determined, and, adjusting for any liabilities incurred by the fund, used to calculate the net asset value ("NAV"). The NAV per share is the intrinsic value of one share of the fund. The key difference between a closed-end fund and an open-end fund is the manner in which the shares change hands. Closed-end funds issue a fixed number of shares only at the inception of the fund (hence the term "closed"). The shares are usually listed on a major stock exchange (PFD and PFO are listed on the NYSE) and the price of the shares will fluctuate based on what a willing buyer would pay for the shares of a willing seller(just like buying or selling shares of Microsoft or any other listed company). The price may or may not bear a close relationship to the NAV. If the market price is above the NAV, the Fund is said to be trading at a "premium". If the market price is below the NAV, the Fund is said to be trading at a "discount". Open-end funds issue new shares and redeem old shares daily (hence the term "open"). During business hours, investors may indicate to the fund their desire to purchase or sell shares in the fund. The fund will compute the NAV as of the close of business and either issue new shares or redeem outstanding shares at that NAV. There
are other important differences (for example, it is more common for closed-end
funds to employ leverage), but the key difference is the mechanism for
trading the shares of each.
How
does Preferred Income Fund (PFD) differ from Preferred Income Opportunity
Fund (PFO)?
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