Hedging and Leverage
Preferred Securities and Hedging Strategy
are the differences between traditional preferreds and hybrid preferreds?
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.
does each Fund produce income?
does leverage impact the amount of the dividend?
The mechanism is pretty straightforward - if long-terms rates rise significantly, the hedging instruments used by a Fund should under normal market conditions 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. Please note that on a temporary or extended basis, the Adviser may determine that hedging Fund holdings is not likely to produce these results. If it does, the Adviser may not utilize any hedging strategy for a Fund or may limit hedging to a large extent, and the above results would not occur. Consequently, the Funds could have less protection of NAV and could generate less income than if the hedging strategies had been used.
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 U.S. Treasury 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, generally it is better to have the insurance and not need it than to need it and not have it. However, the Funds may not hedge the interest rate exposure of the portfolio if the Adviser believes that the cost of hedging outweighs the likely benefits of it. Similarly, when viewed historically, if it turns out that the cost of hedging did outweigh the benefits (either because long-term U.S. Treasury rates did not rise significantly or because the hedging instruments the Funds employed did not perform as expected), each Fund will have paid for insurance it ultimately did not need.
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.
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.
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.
How does each Fund report the breakdown between dividends and interest?
I reinvest dividends directly into the Funds and is there any benefit
over purchasing shares in the open market?
does "Ex-Div"refer to?
Why did I receive 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.
Section 19 notice generally does not accompany every dividend payment,
and the need to send such notice is determined by each Fund individually.
Hedging and Leverage
light of recent market conditions, have the Funds altered their hedging
does the slope of the yield curve impact the cost of the Funds' hedging
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, 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, if the hedging strategy is then being employed, 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.
we have explained in the past, the first two effects tend to generally
offset the 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.
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 options-based 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.
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 option-based
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.
do swaptions add to each Fund's hedging strategy?
can investors purchase shares of Common Stock of either Fund?
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.
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.
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.
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.
does Preferred Income Fund (PFD) differ from Preferred Income Opportunity