Preferred Securities


Hedging and Leverage

Other Topics

Preferred Securities and Hedging Strategy

What is a preferred security?
A preferred security is a creature of both equity and debt. It ranks in between a bond and common stock in a company’s capital structure, typically is either perpetual or has a very long maturity and, yet, it pays dividend or interest amounts which may be fixed or floating according to the terms of the issue and it does not directly participate in the growth or profitability of the company.

Because of these equity features and its longer duration, a preferred security will yield higher than a bond of the same issuer. In fact, because of the generally higher credit quality of preferred securities issuers, preferred securities are generally the highest-yielding securities of investment-grade companies.
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What are the credit characteristics of preferred securities?
In the event of liquidation, preferred shareholders must be paid all dividends and principal before distributions may be made to common shareholders. Many preferred securities are listed on major stock exchanges, and specialized trading departments of several investment brokerage firms further enhance liquidity.

Some preferred securities may be convertible into the common stock of the issuing corporation.

Returns from investment grade preferred securities correlate much more closely with investment grade bonds and U.S. Treasury securities than with common stocks or "junk" bonds.
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What are the income characteristics of preferred securities?
Preferred securities pay dividends or interest at either a fixed-rate or a variable rate determined either by formula or through a Dutch auction process. Because of the ranking of preferred securities, an issuer may not pay income to its common shareholders without first paying all its current obligations to holders of its preferred securities. In some circumstances, the issuer may, however, pay its debt holders without paying anything to its preferred holders.

Dividends and interest payments can be either cumulative or non-cumulative. If cumulative, all dividends or interest payments that have not been paid will accumulate and must be paid before holders of common stock receive any dividends. If non-cumulative, the company may elect not to pay a particular periodic dividend to preferred holders without any further obligation to repay that dividend.

In certain instances, failure to pay preferred dividends may entitle preferred shareholders to representation on the company’s board of directors.
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What are the differences between traditional preferreds and hybrid preferreds?
It is all basically a matter of taxes. In other respects, the two are really very similar. Traditional preferreds are treated for tax purposes just like any other equity security such as common stock. The issuer receives no deduction for tax purposes for dividend payments made to holders of preferred shares. On the other hand, those dividends are 70% tax free to corporate investors due to the Dividend Received Deduction ("DRD"). The purpose of the DRD is to eliminate in part the double taxation of these dollars at the corporate level that would otherwise occur. Additionally, these securities generally classify as qualified dividend income (QDI) to individual investors. QDI is currently taxed at 15% for most individual investors and a rate of 20% for very high income investors.

Hybrid preferreds were created in the mid-1990s for the purpose of allowing issuers to get a deduction for 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 as neither Flaherty & Crumrine nor Destra Capital provides tax advice.
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What are a few advantages of utilizing institutional preferred securities?
The advantages to having access to both the institutional and retail preferred markets are evident in the current environment, particularly when comparing the preferred securities exchange-traded fund (“ETFs”) vs the Flaherty & Crumrine preferred securities closed-end funds. Generally, ETFs are limited to only listed preferred securities (typically on the NYSE), which constitute only about 50% of the total preferred securities market. The balance of the preferred market trades over-the-counter, a market that is generally unavailable to retail investors. The issues in this institutional market generally have better call protection and trade at higher yields.
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How does each Fund produce income?
Each Fund invests in a portfolio of income producing securities consistent with its objectives and guidelines. Each Fund's strategy is pretty straightforward - maximize income over the long term, while not exposing the Fund's net asset value to unnecessary risk. Over the long run, the income generated by a Fund's securities portfolio will be influenced primarily by two things - the level of long-term interest rates (typically measured by the yield on 30 year U.S. Treasury bonds) and the relationship of yields on the preferred securities held by the Fund to those long-term interest rates.
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How does leverage impact the amount of the dividend?
Each Fund uses leverage to enhance returns to the shareholders. Most of the time, the Funds are able to borrow money through their issuance of preferred securities at rates well below the rates we can earn on the investment portfolio. Of course, the benefit of leverage is greatest when the "spread" between the income generated by the portfolio and the cost of leverage is wide. However, the converse is also true; leverage doesn't provide as much income when the spread is narrow.
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Does the hedging strategy impact the amount of the dividend?
Each Fund may, but is not required to, employ a hedging strategy. When employed, is designed to do two things:

  • Protect the Fund's net asset value from significant increases in long-term U.S. Treasury rates which occur over a short period of time; and,

  • Enable the Fund's dividend rate to increase if long-term U.S. Treasury rates increase significantly over a short period of time.

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.

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.
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How does each Fund balance the factors that affect the dividend?
Income, leverage cost and hedging cost create a three-legged dividend stool, and each leg can move up or down for different or similar reasons. Trying to forecast changes in one leg is difficult enough, let alone three. Consequently, projecting a dividend amount is a mixture of art and science, and becomes more difficult the further out in time we look.

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.
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How does each Fund report the breakdown between dividends and interest?
Each Fund calculates the breakdown between Qualified Dividend Income (QDI) and interest and report it to shareholders on Form 1099 after the end of the calendar year. We also publish the breakdown on the Funds' website and in the Annual Report to Shareholders.
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Can I reinvest dividends directly into the Funds and is there any benefit over purchasing shares in the open market?
The answer to both questions is yes. Each Fund's Dividend Reinvestment Plan (the "DRIP") provides a means of acquiring additional shares of the Fund without paying the full market premium, if any. When the market price is above NAV, new shares will be issued to participants in the Plan at the higher of NAV or 95% of the then current market price. Participating shareholders can therefore receive a discount on their reinvested shares of up to 5% of the market price. If the market price of the shares is below the NAV, the Plan purchases shares in the open market. The brokerage commission charged for acquiring these shares is competitive with most "discount" brokers. Shareholders should be aware that not all broker-dealers participate in the Fund's dividend reinvestment plan. If your shares are held in a brokerage account, ask your broker if his/her firm is set up to participate. If you hold your shares in certificate form, or if you would just like more information, call PFPC Inc., at 1-800-331-1710.
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What does "Ex-Div"refer to?
Every month the Funds pay dividends, and the value of the dividend is subtracted from the Funds' NAVs on the Ex-Dividend date each month. So when the NAVs are reported with an "Ex-Div" behind them, it means that the amount of the dividend has been taken out of the Net Asset Value.
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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.

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

Does the Fund currently employ a hedging strategy?
As a result of the credit crunch that began in July 2007, there has been a lower correlation between changes in the value of preferred securities and the put options on Treasury bond futures that the Fund would normally use to hedge its preferred securities. Preferred securities have tended to trade more based on credit quality than on changes in interest rates as expressed in Treasury bond rates. At the same time, the cost of hedging has increased as short-term interest rates have dropped substantially below long-term rates and interest-rate volatility has increased. As a result, the Fund does not currently use any instruments to hedge against significant increases in long-term interest rates. The Fund continues to evaluate the potential benefits and costs of hedging . At any particular time, all, none or some portion of the Fund’s holdings may be hedged.
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What are interest rate swaps and swaptions?
Although their name sounds rather strange, interest rate swaps are one of the most widely used forms of derivative contracts. A swaption is simply an option to enter into an interest rate swap on pre-determined terms if that turns out to be attractive to do before the option expires. Similar to the put options on Treasury bond futures contracts that the Fund purchases as hedges, the entire price paid for the swaption is at risk. However, that is the most that a purchaser of a swaption can lose on the contract. For this reason, swaptions are probably more interesting to each Fund than swaps.

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.

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 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.
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Other Topics

How can investors purchase shares of Common Stock of either Fund?
Both Funds' shares trade on the New York Stock Exchange (NYSE) under the symbols "PFD" and "PFO." As with any other companies listed on the NYSE, investors can purchase or sell shares of Common Stock of either Fund during normal business hours of the NYSE through a registered broker-dealer.
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Why do the Funds trade at premiums or discounts to NAV?
PFD and PFO are closed-end investment companies. Closed-end funds have inherent advantages over traditional mutual funds (or "open-end funds"). For example, a closed-end fund like PFD or PFO can use preferred stock leverage and as a fixed pool, it can fully allocate its assets to higher yielding securities without regard to the volatile inflows and outflows associated with the shareholder purchases and redemptions that occur in open-end funds. Both these advantages can work to increase the distributions paid to PFD's and PFO's shareholders.

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.
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What are the differences between "closed-end funds" and "open-end funds"?
Closed-end funds such as PFD and PFO differ from open-end funds in some very important ways.

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.
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