This Diversified Mix Of High Yield Asset Classes Hits The Right Notes
Riding The Gravy Train Again
Every week, we’ll profile a high yield investment fund that typically offers an annualized distribution of 6-10% or more. With the S&P 500 yielding less than 2%, many investors find it difficult to achieve the portfolio income necessary to meet their needs and goals. This report is designed to help address those concerns.
After years of historically low yields, income seekers have finally been riding the gravy train again. Investors can capture nearly a 5% yield on risk-free Treasuries without even having to take on duration or credit risk. As the Fed begins what’s expected to be a lengthy rate cutting cycle, however, the new trend in interest rates is likely to be lower. That, of course, will ultimately depend on a number of factors, such as economic strength, inflation and the labor market, but yield seekers may need to prepare for an environment where capturing those yields could become a little more challenging.
One asset class that investors might want to consider is preferreds. These are securities that rank higher on the capital stack than common stock, but behave a lot more like fixed income. However, because they maintain some stock-like characteristics, they’re often viewed as a hybrid between the two asset classes. That produces the benefits of a high yield security with some potential stock market upside at the same time. With stocks looking poised to keep rising as the high level economic numbers still look good, this type of hybrid structure could be particularly attractive to income seekers. Today, we’ll look at the Cohen & Steers Limited Duration Preferred & Income Fund (LDP), a fund that offers high yield, but caps duration risk, making it a potentially attractive option should conditions in the markets start turning south.
Fund Background
LDP’s primary investment objective is high current income through investment in preferred and other income securities. The secondary investment objective is capital appreciation. The fund seeks to achieve its investment objectives by investing at least 80% of its managed assets in a portfolio of preferred and other income securities issued by U.S. and non-U.S. companies. It also seeks to reduce the risk of rising interest rates by maintaining, under normal market conditions, a portfolio duration, excluding the effects of leverage, of six years or less. The fund utilizes leverage in order to enhance yield and total return potential.
This fund uses a fairly standard approach to security selection, so the portfolio itself doesn’t really contain any undue risks. The credit quality profile looks similar to a standard preferred index. There are two big differences though. LDP is about 55% traditional fixed income, 35% preferreds and 10% convertibles, so the composition is much more diverse. Second is the use of leverage, which currently stands at a relatively high 33%. That’s going to alter the fund’s risk profile substantially and will increase the total cost of ownership. For many investors, this could come down to whether they want a more standard high yield portfolio or they want to take a chance by ratcheting up the exposure via leverage.
Overall, I think there’s a lot to like about the portfolio allocation. Not surprisingly, it tilts heavily towards banks and other financial institutions. The double-digit weighting to insurance companies looks good and should provide a little different profile than the standard bank issuers. Utilities provide a bit more of a rate-sensitive profile, but could provide a steadier source of income. The international exposure provides a strong measure of diversification, although it hasn’t necessarily paid off in terms of returns lately. I like that it focuses on developed market issuers, which helps avoid a potential source of risk.
As I mentioned earlier, the overall credit profile looks very similar to what you’ll find in a standard preferred portfolio, although LDP comes with much more diversity. About half of the portfolio is in investment-grade securities (although it’s almost entirely in the BBB bucket) and the other half is in junk/unrated securities. The fund doesn’t dive too deep into low-rated bonds, which I view as advantageous in the current environment even though junk-rated securities have been rewarded over the past couple years.
The top of the portfolio consists almost entirely of big banks, which should add a degree of stability. This is fairly common to see within portfolios, such as these, and represents overall average market risk.
LDP was launched in July 2012. Since its inception, the fund has returned a total of 131%, which translates to around 7% annually.
This is actually strong performance within this category and earns the fund a 5-star rating from Morningstar. Versus a blended benchmark, LDP has outperformed by roughly 1.5% annually. The NAV degradation over the past decade is relatively minimal, although there are definitely some periods of volatility in there. That volatility can have a modest degree of impact on the fund’s distribution schedule and we’ll see in a moment that this has been the case with LDP.
For using 33% leverage, LDP isn’t quite as excessively volatile as I would have expected. The gap on short-term volatility is currently well over 50% higher for LDP, but there have been many periods where risk levels are comparable. On a longer-term basis, the fund is only about 30-35% more volatile than an all-preferred portfolio and has stayed in that range since the COVID pandemic.
This, of course, is an imperfect benchmark and could be skewing our view of the risk profile a bit, but I think the overall takeaway is that LDP might not be as overly volatile as one might think.
LDP has historically seen its premium/discount to NAV hover in a tighter range. Just a couple of months ago, the discount wasn’t far from the -10% level, which would have represented good value based on where the discount has been in the past. It rapidly shrunk to just -2% now, which puts it back at the higher end of the range. The quick gains seem to have been gotten, but I wouldn’t rule out this number turning into a premium if lower-rated debt remains in favor the way it has.
Macro Environment
Fixed income has been a tale of two markets this year. Lower-rated debt, including traditional junk bonds and senior loans, have done the best, while the high quality stuff, long-term Treasury bonds in particular, are still in the red. I’ve said for quite a while now that I don’t like how credit conditions appear to be deteriorating at the same time that high yield spreads are near historical lows. That combination creates an unbalanced risk/return profile that could hurt income investors if those risks ever get priced in.
The issue is that investors seem to have no motivation to properly price credit risk here. Those credit risks remain, but as long as GDP growth rates look healthy and inflation appears to be under control, investors seem satisfied with where things are at. In other words, they’ll keep buying junk debt despite requiring very little additional yield to take on the risk.
Being that preferreds fall higher on the capital stack means that there’s some less risk involved, despite some of these securities being rated below investment-grade. Same thing for the convertibles, which can be flipped into stocks if they keep rallying. The junk bond sleeve of this portfolio presents, in my opinion, the biggest downside risk at the moment. That being said, the notion of the Fed lowering interest rates and the government likely adding liquidity to the system in Q4 mitigates some of that risk.
Conditions seem more favorable for the asset classes held within this fund for the short-term, but I’m still skeptical about any time frame beyond that.
Distribution Policy
LDP maintains a fixed monthly distribution policy that currently pays $0.131 per share, or $1.572 per share annually. At current share prices, that translates to a forward-looking yield of 7.2%.
On the downside, the distribution yield has come way down from its highs of the past two years and now sits near its lowest levels of the past decade. On the plus side, the yield has been plunging because total returns have been really good! Over the past year, LDP is up roughly 40% and I’m guessing a lot of investors would happily make that trade-off!
From purely an income standpoint, however, the news isn’t quite so positive.
The fund’s distribution was cut in July 2023, January 2022 and July 2020. That’s 18 months apart in each case (although the distribution was rock solid prior to that). By that timeline, we could be due for another cut, although it wouldn’t be appropriate to count on that just based on history. The earnings coverage ratio, however, is falling into the 70-80% range, which suggests the fund is failing to generate the income necessary to support the distribution. Given the recent share price gains, I think it’s entirely reasonable to think the fund could augment the income generated with accrued capital gains to make up the difference for now without needing to return capital. I think the distribution is probably OK for the time being.
Advantages
The fund has a stellar historical performance record. While yield is usually the deciding factor for investors when it comes to closed-end funds, its total return is what it really comes down to.
The mix of convertibles, preferreds and junk bonds provides a different mix of credit and risk profiles. This allows the fund to still generate a high yield, but diversifies away some risk in the process.
Despite the high use of leverage, LDP doesn’t have the especially high degree of volatility that typically comes with that. I wouldn’t necessarily count on that going forward, given how the impact of leverage can change quickly, but it has made historical risk-adjusted returns look a little better.
Disadvantages
The current discount to NAV has narrowed to the point where there’s no real value built into shares at their current prices.
Thanks to the high cost of implementing the fund’s 33% leverage overlay, its expense ratio ends up being more than 4%. That’s going to be a significant anchor to achieving long-term returns.
Conclusion
I like this fund overall. It’s got a nice asset mix for income seekers. The yield of 7-8% still looks quite attractive. It doesn’t take any excessive risks in the portfolio construction process. The 5-star rating from Morningstar indicates that the managers have done a really nice job in the security selection process.
I’m not crazy about the high leverage or the downside risk that looms if credit market risk starts getting priced in. But this fund has built up a solid long-term history and that should be recognized.
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