FPF: Valuation Isn’t Too Attractive Despite Higher Distribution For 2024 (NYSE:FPF)

Written by Nick Ackerman, co-produced by Stanford Chemist.

With hotter-than-expected inflation data, we could be looking at interest staying higher for longer. That could bode well for funds that look specifically for “limited duration” or “intermediate duration.” One such fund in the preferred and income space is the First Trust Intermediate Duration Preferred & Income Fund (NYSE:FPF).

With a rather narrow discount over the last year, the fund may not be looking like the best candidate for picking up a position today. On the other hand, the valuation looks to indicate it is trading at around its fair value based on the longer-term average levels. That could suggest that those holding this may also not need to be in a hurry to sell.

FPF Basics

• 1-Year Z-score: 1.31.
• Discount: -7.72%.
• Distribution Yield: 9.27%.
• Expense Ratio: 1.42%.
• Leverage: 33.42%.
• Managed Assets: $1.731 billion.
• Structure: Perpetual.

FPF’s investment objective is “to seek a high level of current income.” In order to achieve that, the fund will invest “at least 80% of its managed assets in preferred securities and other income-producing securities issued by U.S. and non-U.S. Companies, including traditional preferred securities, hybrid preferred securities that have investment and economic characteristics of both preferred securities and debt securities, floating-rate and fixed-to-floating rate preferred securities, debt securities, convertible securities, and contingent convertible securities.” Further, the fund looks to target a duration between 3-8 years.

This fund is focused on investing in a basket of preferred securities and “other income-producing” securities; however, similar to most other preferred funds in the closed-end fund space, they also carry a meaningful allocation to contingent convertible capital securities. CoCos, or AT1 bonds, grabbed headlines during 2023’s banking crisis when Credit Suisse saw their AT1 bonds completely wiped out. As of the fund’s last annual report, those accounted for around 28% of the invested assets.

The fund is leveraged, which is not unusual for preferred CEFs. With leverage costs, the fund’s total expense ratio comes to 4.34%. Similar to most leveraged CEFs, the fund has seen its borrowing costs rise materially as the Fed was raising its target rate. At the end of fiscal 2022, the fund’s total expense ratio was 2.22%, and in 2021, it came to 1.72% to provide some context on just how much impact there was. This is another place where lower rates would help this fund as it would see its borrowing costs come down.

Fair Discount Level Over The Long Term

Today, the fund’s discount isn’t looking that attractive if we look simply at the last 1-year average. That’s why the fund’s 1-year z-score is positive at 1.31. That said, with the fund’s longer-term history, it has actually traded at a premium on more than one occasion. That’s resulted in the fund’s longer-term average actually being quite different from what we saw over the last year.

It has made the last year look like the outlier relative to the rest of the fund’s history. Of course, during Covid, there was a significant spike, which we’ve seen in plenty of other CEFs. So, on the valuation front, the fund’s current discount would appear to be trading around a fairly reasonable level – even despite the shorter term, where it appears more pricey these days.

Comparison To Peer

Another preferred fund that also focuses on limiting its duration is the Cohen & Steers Limited Duration Preferred and Income Fund, Inc. (LDP). This fund shows a similar pattern to that of FPF. It is likely that the higher rate environment is making investors more cautious about investing in this space. Given that they are leveraged funds, a wider relative discount makes sense, too. On a relative basis, LDP only looks ever so slightly like the better of the two.

At the end of February 29, 2024, FPF’s weighted average effective duration was 3.93 years. At the end of December 31, 2023, the average modified duration for LDP was 3.4 years. This suggests that FPF is slightly more sensitive to interest rates. That could explain some of the reasons why FPF has underperformed over the last three years relative to LDP.

However, there was also another significant factor here at play. LDP’s management, Cohen & Steers, set their funds up better for a higher rate environment. They did this by hedging their borrowings, and while borrowing costs rose, their interest rate swaps gained value. FPF, like several other preferred funds, did not hedge their portfolios for the higher rates.

In hindsight, it is always easy to look back and see what a management team should do, but it is also important to remember that hedging does come with a cost. While it did seem all but certain that rates were definitely heading higher, the actual pace of those increases came more aggressively than some management teams thought.

Further, this is another place where, if rates come down in the future, FPF could become the outperformer. This could be the case with their slightly longer duration, but also, the hedges that are put in place will start to lose value if rates come down.

Over the longer term, the funds seemed to perform almost identically. It was more so in the last few years now where that divergence has played out between the two.

FPF’s Distribution

Recently, FPF bumped up their distribution, perhaps as they anticipate rates to come down and that would provide more net investment income generation for the fund. One area to always check for seeing a distribution bump that doesn’t seem warranted is also if there is an activist building a position. In this case, nothing showed up on that front.

The increase could be some of the reason for the fund seeing its discount narrow regardless. That pushed up the distribution rate to 9.27%; on a NAV basis, it comes up to 8.71%.

As of their last report, the fund’s NII coverage came to 87.13%. That isn’t necessarily terrible coverage, but it’s likely that NII has actually declined further since this report. This also doesn’t reflect the now higher distribution that the fund is paying out.

That’s because this is a reflection of the 12 months ended October 31, 2023; there were several more rate hikes during this time. The fund’s reverse repurchase agreement borrowings saw interest rates from 4.49% to 6.10% through this period. The ending rate is 6.07%, which is what we’d expect to see their borrowings push around that higher 6% now.

That’s a level that is similar to the fund’s credit facility, where the average interest rate came to 5.66% through this period, but it finished the FY at 6.17%. In order to see higher NII, they would have had to have more of their fixed-to-floating rate securities kick in during this time.

Though, like most preferred funds, they invest a large portion of their portfolio in the financial industry. When large banks issue these fixed-to-floating rate securities, they are also callable. If they can issue more at a lower fixed rate, they will call those securities. Throughout 2022 and 2023, banks were doing that on a number of their preferred. It’s more the smaller companies that will generally let their preferred start to float if they can’t issue a cheaper form of borrowing to refinance it.

That’s why the fund’s listed ~80% allocation to fixed-to-floating rate and fixed-to-variable can seem impressive, but it may not ultimately be a huge driver going forward. At some point, if rates stay higher for longer, new preferred securities being issued will have to come with a higher dividend yield. That will bode well for FPF, but the transition between the fund being able to get a higher-yielding portfolio relative to the leverage costs going up immediately takes some time.

Meaning that if I had to make an educated guess, the floating rates that will start to kick in and don’t get called could be a minority of the portfolio. That likely means that it isn’t enough to offset the higher borrowing costs the fund will be seeing currently, and that means NII will decline. So coverage was somewhat strong, but between a lower NII and a now higher payout, it’s likely declined. Though they clearly were comfortable with raising it anyway, I suspect the current payout will last for a period of time.

That also means that, for tax purposes, the fund is likely to see higher return of capital distributions going forward, as it has already been. A declining NAV during this period would mean we are seeing destructive ROC.

FPF’s Portfolio

As we noted above, the fund has a sizeable allocation to contingent capital securities. These aren’t listed in the fund’s allocation breakdown as a separate line; instead, they are lumped in with the “capital preferred securities.”

I’m not sure why that is, but the fund’s annual report highlights it in the footnotes. That’s where we can see that the fund has a 28.5% allocation to these securities.

(J) This security is a contingent convertible capital security which may be subject to conversion into common stock of the issuer under certain circumstances. On October 31, 2023, securities noted as such amounted to $447,750,617 or 28.5% of managed assets. Of these securities, 8.0% originated in emerging markets, and 92.0% originated in foreign markets.

That can be important to note because it plays a part of the fund’s mixed benchmark for comparison purposes.

…a blend of 30% of the ICE BofA Core Plus Fixed Rate Preferred Securities Index, 30% of the ICE BofA US Investment Grade Institutional Capital Securities Index, 30% of the ICE USD Contingent Capital Index, and 10% of the ICE BofA US High Yield Institutional Capital Securities Index.

In total, the financial sector, primarily the banks and insurance industries, makes up nearly 70% of the fund’s sector exposure.

Of that, we see that most of the portfolio is invested in investment-grade quality. Although it’s primarily BBB, and that’s only one rung into investment grade, it is investment grade nonetheless. That accounts for nearly 66% of the portfolio’s assets.

In looking at the fund’s top ten more specifically, we see a number of these financial institutions. We can see just how diversified this fund is, as not only one position has an allocation of over 2%. Also, with little surprise, we can see that five financial institutions are also included in the fund’s top ten.

However, they aren’t necessarily some of the more significant financial institutions outside of Wells Fargo & Company (WFC) and Bank of America Corporation (BAC). Those are generally names that regularly show up in the preferred CEF peers, such as Cohen & Steers and Flaherty & Crumrine. Those funds often feature a number of other bellwether G-SIB banks, such as JPMorgan Chase & Co. (JPM) and Citigroup Inc. (C) as well.

That said, seeing companies outside the U.S. isn’t unique to just this fund. This is another fairly common characteristic of this fund and its preferred peers. It comes from the fund’s more global approach. Nearly all the preferred funds hold allocations outside of the U.S. In the case of FPF, the U.S. accounts for about 50% of its assets.

Conclusion

FPF provides a choice for an investor looking in the intermediate preferred security space. Similar to most preferred CEFs, higher interest rates rocked the fund, and they didn’t hedge against that. That saw it perform relatively weaker compared to LDP, a Cohen & Steer fund that did hedge against rates. That could make LDP look like the more appropriate fund at this time if one is expected for rates to stay higher for even longer. At the same time, if one expects rates to be cut soon then FPF could be in a better position as that hedging won’t be holding the fund back.

With all that said, neither fund looks like a particular steal in terms of valuation here. Based on the current discounts, I’d be comfortable hanging on to either, but being more patient could be prudent for a better valuation to add.