HPI: This Fund Is Navigating The Current Environment Well, But It Is Pricy

seekingalpha06-04

Yuji Sakai The John Hancock Preferred Income Fund (NYSE:HPI) is a closed-end fund that can be purchased by income-focused investors as a method of achieving their goals that involve the generation of ...

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The fund manages to do fairly well at this, as it currently boasts an attractive 8.88% yield at the current share price. This is one of the highest yields currently possessed by any preferred stock fund, as we can clearly see here:   Fund Name Morningstar Classification Current Yield   John Hancock Preferred Income Fund Fixed Income-Taxable-Preferreds 8.88%   Cohen & Steers Select Preferred & Income Fund (PSF) Fixed Income-Taxable-Preferreds 7.76%   Flaherty & Crumrine Preferred Securities Fund (FFC) Fixed Income-Taxable-Preferreds 7.22%   First Trust Intermediate Duration Preferred & Income Fund (FPF) Fixed Income-Taxable-Preferreds 9.31%   Nuveen Preferred & Income Opportunities Fund (JPC) Fixed Income-Taxable-Preferreds 7.95%   Click to enlarge As we can clearly see here, the only fund whose current yield manages to exceed that of the John Hancock Preferred Income Fund is the First Trust Intermediate Duration Preferred & Income Fund. In addition, John Hancock's other two preferred stock closed-end funds have comparable yields, but I do not like to include two funds from the same fund house in a comparison chart. Thus, we can clearly see how an investor whose goal is to maximize current income might be reasonably satisfied here, as well as how the fund could be attractive to such an individual. However, this fund shares the same problem as most other fixed-income funds today in that its current yield may not be sufficient to keep up with the rising cost of living if the fund is held in a taxable account. I described this problem in great detail in a previous article. From that article: In recent decades, many have criticized the way CPI figures are calculated, highlighting their limitations in accurately capturing real inflation, or even pointing to bias on the part of their publishers. Chief among these problems is the very basis of the calculation: the concept of a \"fixed basket\" representing a predetermined set of goods and services that reflects the average consumption pattern in a specific base year. This includes basic foods and beverages, housing rental, clothing, transportation and medical care costs, as well as education, communication and recreational expenses. Alternative methods of calculating inflation show that the cost of living is rising at about 8% annually right now, and an 8.88% yield is not sufficient to outpace that once taxes are paid on the money distributed. Thus, investors in this fund might be losing purchasing power if they are holding it in a taxable account. This is a problem with pretty much any fixed-income fund though, not just the John Hancock Preferred Income Fund. As regular readers can likely remember, we previously discussed the John Hancock Preferred Income Fund on February 13, 2024. The market for investment-grade bonds since that time has been fairly weak, although most other types of fixed-income securities have held up pretty well. The John Hancock Preferred Income Fund in particular has delivered a remarkably strong performance, as its shares have appreciated by 4.05% since that article was published: Seeking Alpha As we can see, the fund's shares outperformed both the Bloomberg U.S. Aggregate Bond Index (AGG) and the ICE Exchange-Listed Preferred & Hybrid Securities Index (PFF) by quite a lot over the period. It is difficult to understand why preferred securities would hold up so well during a period of rising interest rates. The fund's net asset value is up 3.96% over the period, though: Barchart As such, it is logical that the fund's share price would increase to the degree that it did, despite it being difficult to see why preferred stock is performing so well in the market right now. After all, preferred stock is a fixed-income security that should perform similarly to bonds. As I pointed out in a recent article: A simple look at a closed-end fund's price performance does not necessarily provide an accurate picture of how investors in the fund did during a given period. This is because these funds tend to pay out all of their net investment profits to the shareholders, rather than relying on the capital appreciation of their share price to provide a return. This is the reason why the yields of these funds tend to be much higher than the yield of index funds or most other market assets. When we include the distributions paid out by the John Hancock Preferred Income Fund as well as both the investment-grade bond and preferred stock indices since February 13, 2024, we get this alternative performance chart: Seeking Alpha We can immediately see that investors in the John Hancock Preferred Income Fund realized a significantly higher total return than investors in either of the two market indices. This is not surprising, as fixed-income closed-end funds usually outperform their benchmark indices over any sort of extended period. This is due to the much higher yields paid out by these funds, which provide a commensurate boost to the total return. The fund's strong recent performance does not necessarily mean that the fund will be a great investment for new money right now, though. Let us have a look at how the fund is today and attempt to make a determination of its prospects as an investment. About The Fund According to the fund's website, the John Hancock Preferred Income Fund has the primary objective of providing its investors with a high level of current income. The website does not, however, provide an in-depth description of the fund's strategy. Rather, all it states is that the fund focuses on investing in traditional and convertible preferred stock: John Hancock/Edit by Author It would be nice to have a bit more information than just this, especially because preferred stock and convertible preferred stock exhibit different performance characteristics. In particular, convertible preferred stock has much more upside potential. The fund's fact sheet does not add much to the website's description, however. It simply states that 50% of the fund's assets will be invested in investment-grade securities. This actually makes it more difficult to understand the fund's recent performance, as junk bonds have outperformed investment-grade securities year-to-date: Seeking Alpha If this fund was investing primarily in investment-grade assets, we would expect that it would take a performance hit compared to what it would have if it invested primarily in junk-rated securities. With that said though, it is more heavily weighted to junk-rated securities than we might expect: Fund Fact Sheet The above chart comes from the fund's fact sheet dated March 31, 2024. As we can see, 51.30% of the fund's assets were invested in BBB-rated securities as of that date. The fund had another 1.56% of its assets invested in U.S. Government & Agency securities, which are technically rated AAA or AA depending on which credit rating agency judged them. We also see a 2.12% allocation to A-rated securities. The remainder of the fund is invested in junk debt or equity. It is a 42.71% weighting to junk debt, which is just under 50% and higher than I really expected to see in a preferred stock fund. After all, these funds frequently invest significantly in securities issued by banks, and it is doubtful that any bank with a junk debt rating would be trusted by either regulators or its own customers. Here are the largest issuers whose securities are held by the John Hancock Preferred Income Fund: John Hancock As I stated in a recent article on one of this fund's sister funds: The first thing that we notice here is that all of the companies in the fund's largest positions list are either utilities or banks. This is not uncommon for a preferred stock fund because banks and utilities are the largest issuers of preferred stock in the market. As a result, almost any preferred stock fund will be very heavily weighted towards these two types of companies. With that said though, usually the overwhelming majority of companies in the top ten list are banks. This is due to international banking regulations that require banks to hold a certain percentage of their assets in the form of Tier one capital. Tier One capital refers to that proportion of a bank's assets that are not simultaneously a liability to somebody else (such as a depositor). When regulators require that a bank increase its Tier One capital, its only options are to issue either common or preferred stock. The bank will often choose to issue the preferred stock in order to avoid diluting the common stockholders. A utility does not have these regulations to follow but they become heavy issuers of preferred stock due to the cost of their infrastructure. The utility company will often finance the construction of this infrastructure with debt, but the company will usually want to avoid taking on too much debt and becoming overleveraged. Thus, it will often issue preferred stock to partially cover the expenses so that it can avoid too much debt or common stock dilution. The majority of the things shown on the top ten list are either banks or utilities:   Company Industry   $Bank of America Corp(BAC-N)$. (BAC) Banking   Morgan Stanley (MS) Banking   The PNC Financial Services Group (PNC) Banking   CMS Energy Corp. (CMS) Utilities   Wells Fargo & Company (WFC) Banking   Energy Transfer LP (ET) Oil and Gas Midstream   Athene Holding Insurance   Vistra Corp. (VST) Utilities   Algonquin Power & Utilities Corp. (AQN) Utilities   Edison International (EIX) Utilities   Click to enlarge Interestingly, though, we can see that there are just as many utility companies as banks in the fund's top ten list. We see four banks, four utilities, an oil and gas midstream partnership, and a rather unique life insurance company in Athene Holding. This is somewhat different from many preferred stock funds in that less than half of the companies that comprise the fund's largest holdings are banks. The website does not provide a breakdown of the fund's portfolio by industry, which is disappointing. It would have been nice to see if this relatively even split between banking and utilities extends over the remainder of the portfolio. The fund's semi-annual report provides this sector allocation: Fund Semi-Annual Report However, we note that this composition report shows what the fund had on January 31, 2024. That might be different from what the fund has today, as there are signs that the fund's management may have decreased its allocation to banks. After all, the fund's semi-annual report provides this top ten issuers list: Fund Semi-Annual Report This shows five banks and an insurance company, but the website's chart shows four banks. Notably, Citigroup (C) is not listed among the fund's top positions on the website. However, Bank of America, Morgan Stanley, Wells Fargo, and PNC Financial Services all show much lower weightings here than the fund's website shows. Thus, there are two possibilities here. The first possibility is that the fund did reduce its banking sector allocation over the past three months. This would make sense given that there have been signs of rising stress in the banking sector ever since the Federal Reserve ended the Bank Term Lending Facility in March. The second possibility is that the fund simply sold off the Citigroup stake and used the proceeds to increase its allocation to some of the other major American banks, which essentially kept its overall banking sector exposure about the same. Neither the website nor any other source of information provided by the fund as of the time of writing seems to offer insight into which possibility is correct, which is disappointing. Hopefully, we will have an answer when the fund releases its third-quarter holdings report (which would tell us its assets as of April 30, 2024), but that has not happened yet. As we saw earlier in this article, the John Hancock Preferred Income Fund states on its website that it invests primarily in traditional and convertible preferred stocks. However, it does not explicitly state the degree to which it invests in these securities. The website simply states: [The Fund is] focusing on preferred stocks and preferred convertible securities, which share characteristics of both equities and bonds. It turns out that the proportion in which the fund invests in preferred stock is lower than we would expect. According to the fact sheet, only 51.57% of the fund's assets are invested in preferred securities: Fund Fact Sheet We can see a 44.55% allocation to corporate bonds here, which is very surprising. The name of this fund alone suggests that it would be invested in preferred stock or similar hybrid securities. This may be important when we consider that both investment-grade and junk bonds have underperformed preferred stock year-to-date: Seeking Alpha Thus, the fund's bond allocation could be costing it performance. After all, that is a large enough allocation for the underperforming bonds to be negatively offsetting the performance of the preferred stock to a certain extent. Leverage As we discussed in the previous article, the John Hancock Preferred Income Fund employs leverage as a method of boosting the effective yield of the assets in its portfolio. I explained how this works previously:  Basically, the fund borrows money and then uses that borrowed money to purchase preferred stocks and bonds. As long as the preferred assets have a higher yield than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. As this fund is capable of borrowing at institutional rates, which are considerably lower than retail rates, this will usually be the case. However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we should ensure that the fund is not employing too much leverage because that would expose us to an unacceptable level of risk. I generally prefer a fund's leverage to be under a third as a percentage of its assets for this reason.  As of the time of writing, the John Hancock Preferred Income Fund has leveraged assets comprising 37.98% of its portfolio. This is a marked decrease from the 38.11% leverage ratio that the fund had the last time that we discussed it, which is certainly understandable. After all, as we saw in the introduction, the fund's net asset value has gone up since the last time that we discussed this fund. Thus, the fund's outstanding debt represents a smaller percentage of a larger portfolio. However, the fund is still above the one-third of assets level that we would ordinarily prefer. This does not necessarily mean that the fund is excessively leveraged though, since its ability to handle leverage depends somewhat on the volatility of its assets. Let us compare it to its peers in order to determine if its leverage is appropriate:   Fund Name Leverage Ratio   John Hancock Preferred Income Fund 37.98%   Cohen & Steers Select Preferred & Income Fund 33.60%   Flaherty & Crumrine Preferred Securities Fund 39.50%   First Trust Intermediate Duration Preferred & Income Fund 33.88%   Nuveen Preferred & Income Opportunities Fund 38.83%   Click to enlarge (All figures from CEF Data) As we can clearly see, the John Hancock Preferred Income Fund is not the most leveraged fund out of its peer group. Indeed, this fund represents the median out of this group. As we have seen in previous articles too, this fund has had much higher levels of leverage in the past and its ratio has been declining over the past several months. As such, we probably do not need to worry too much about the fund's leverage. It is, admittedly, not as low as I would like, and we will want to keep monitoring it to make sure that the leverage comes down. For now, though, it does not appear that this fund's leverage is anything to lose sleep over. Distribution Analysis The primary objective of the John Hancock Preferred Income Fund is to provide its investors with a high level of current income. To this end, the fund pays a monthly distribution of $0.1235 per share ($1.4820 per share annually). This gives the fund an 8.88% yield at the current price. Unfortunately, the fund has not been completely consistent with respect to its distribution over its history: CEF Connect It has, however, managed to achieve a greater level of consistency than most fixed-income funds. As I stated previously: As we can clearly see here, the fund has changed its distribution a few times since its inception, but it has generally done a pretty good job of keeping its payouts stable. This is overall a much more attractive distribution history for those investors who are seeking to earn a safe and secure income from their assets than the distribution history of most fixed-income funds. However, it also poses some questions since it seems unlikely that the fund has been able to generate such a stable level of investment profits when its peers have not been able to accomplish the same feat. Let us have a look at how well the fund is covering its distribution. For this purpose, we will use the fund's semi-annual report that corresponds to the six-month period that ended on January 31, 2024. This is a much newer report than the one that we had available to us the last time that we discussed this fund, so it should work pretty well to provide us with an update on the distribution analysis that we conducted in the previous article on this fund. For the six-month period that ended on January 31, 2024, the John Hancock Preferred Income Fund received $14,603,184 in dividends along with $9,626,946 in interest from the assets in its portfolio. From this, we subtract the money that the fund had to pay in foreign withholding taxes to arrive at a total investment income of $24,150,378 for the period. The fund paid its expenses out of this amount, which left it with $13,523,138 available for shareholders. This was not sufficient to cover the $19,665,511 that the fund paid out in distributions over the period. The fund was, fortunately, able to make up the difference via capital gains. For the six-month period, the John Hancock Preferred Income Fund reported net realized losses of $9,934,620, but this was more than offset by $30,176,418 net unrealized gains. Overall, the fund's net assets increased by $15,280,039 after accounting for all inflows and outflows over the period. Thus, the fund did manage to fully cover its distributions during the most recent six-month period, but it had to rely on its unrealized capital gains to do so. This may or may not be problematic because of the fact that unrealized capital gains can be erased by a market correction. The fund's net asset value is up by 2.71% since the closing date of the semi-annual report, so for now, it appears that it is not struggling to maintain the distribution. However, there is still a risk here, since there is a chance that the market is wrong about the speed at which the federal funds rate will decline over the remainder of this year. If that is indeed the case, we could see a correction in preferred stock and fixed-income securities in general that could threaten the fund's ability to cover its distribution if it does not realize the unrealized gains in time. Valuation Shares of the John Hancock Preferred Income Fund are currently trading at a 3.47% premium on net asset value. This is reasonably in line with the 3.11% premium that the shares have had on average over the past month. However, it is important to note that buying shares of any closed-end fund at a premium is a sign that an investor may be overpaying, so caution is urged here. Conclusion  In conclusion, the John Hancock Preferred Income Fund has been delivering much stronger performance recently than what would be expected from a preferred stock fund in today's market environment. The fund has substantially outperformed both the domestic preferred stock and domestic bond markets year-to-date on both a share price and a net asset value basis. The fund's portfolio is perhaps not what we would expect though, as this fund has a very large allocation to corporate bonds despite its stated focus on preferred securities. The fund may be decreasing its allocation to banks and its leverage is declining, both of which are good for risk-averse investors. Indeed, the only real problem here is the fund's valuation, as the shares look very expensive.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.24.2","shortVersion":"4.24.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2440455824"}