We covered Flaherty & Crumrine Preferred Income Fund (NYSE: PFD) and Flaherty & Crumrine Preferred Income Opportunity Fund (NYSE: PFO) previously. Both funds weren’t on our buy list the last time we spoke about them. With another cast cut recently announced, we’re jumping straight into the outlook for these two and telling you if we’ve seen enough pain for a pivot.
Both funds are announcing three months of distributions at a time and PFO is announcing a small, subtle distribution cut of 3%, starting with the May payout.
PFD took this message to the next level and reduced its circulation by 4.9%.
Both funds have always focused on preserving net asset value and paying out what they earn over time. In other words, they don’t care about the “I want my regular cast, main be damned” crowd. Heading into 2022, with the Federal Reserve about as far behind the curve as possible, the writing had been on the wall for a long time.
The funds still bring in a pretty penny. The PFD yields 7.88%. PFO distributing 78.6 cents a year earns 8.26%. We would like to note here that the Y charts are still looking at the past 12 month return and have not yet factored in the reduction. Nonetheless, the chart below provides some context on current performance versus the past decade.
There are a few things we want to note here. The first being that while returns look high, compared to 2020 and 2021, they are not high compared to the past decade. This is especially true if you adjust them to their forward yields. We want investors to avoid the price peg of the past two years where the Federal Reserve and of course investors burst the biggest bond bubble known to man. The unwinding of this bubble has just put yields back in the spotlight.
As anyone who has followed our work knows, we believe that things never stop at the average. What was extremely overvalued will become extremely undervalued. So if you haven’t enjoyed the white-knuckle ride so far, so be it. It will get worse.
The second aspect here is that the last decade has never seen 8% CPI inflation. So whatever returns you’ve received over the past decade, you should logically expect more. The past year has been all about economists and bond bulls (you know who you are), constantly apologizing for completely misleading the outlook.
So we’ve seen a slow and steady sell-off in bonds and other fixed-income instruments as they adjust to reality. After all this sinking reality and selling, these funds are still earning below the official CPI rate, when they were regularly earning 5-6% above the CPI rate.
We have often criticized investors for focusing on a single year of earnings for stocks. The idea of buying The Walt Disney Company (DIS) for example, based on a year of “reopening profits”, ranks among the dumbest we’ve ever heard. Long-term securities should be valued using the time-weighted average outlook. The same goes for preferred stocks. Although they look ridiculously overvalued relative to the CPI, we don’t expect the CPI to average closer to these levels over the next few years. A good way to look at fair value is to see the spread between the distribution yields of these two stocks and the 7-year breakeven inflation rate. The latter is a measure of what the market expects inflation to average over the next seven years.
By this measure, things don’t look as bad as when you compare these returns to the CPI. But they don’t look extremely cheap either.
Mean reversion is extremely painful. When we first wrote about the PFD, it was one of the most overvalued stocks in the earnings space. The feedback that followed was justified.
One of the reasons for the abysmal performance from then on was the premium to NAV (see the big purple line spike in early 2021). Right now, however, both funds are actually at discounts to net asset value.
The three other funds in the same group, Flaherty & Crumrine/Claymore Total Return Fund (FLC), Flaherty & Crumrine Preferred and Income Securities Fund Incorporated (FFC) and Flaherty & Crumrine Dynamic Preferred and Income Fund, Inc. (DFP), are at modest premiums. PFD and PFO therefore have a slight relative advantage here. That said, historically we have seen 10-15% discounts to NAV appear during times of high stress. With the Federal Reserve adamantly hostile, we would seek a double-digit NAV discount to issue a buy rating. We currently rate both funds at Neutral/Hold.
Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.