FLC Fund: Valuation Looking Attractive (NYSE:FLC)
Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on January 27th, 2023.
Flaherty & Crumrine offers five different funds that mostly focus on preferred investments. We recently did a brief update on the Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP). However, another name that is located in the Taxable Income Portfolio at the CEF/ETF Income Laboratory is Flaherty & Crumrine Total Return Fund (FLC). With the latest annual report available for fiscal year-end 2022, it’s time to take an updated look.
We also have the fund at a discount, making it a potentially better opportunity. The fund’s discount has widened since our last update. For many closed-end funds, a discount doesn’t tend to mean anything. Many funds trade at almost perpetual discounts. However, for FLC, the fund hasn’t experienced sustained discounts since the GFC of 2008/09.
Since our last update, FLC has held up relatively well on a total return basis. That was even though interest rates have increased significantly since then. However, it was a rough ride to get to where we are now, and at one point, the fund would have shown some meaningful losses. Below is a comparison with the S&P 500. That isn’t an appropriate benchmark, but it can give us some context of how FLC has done relative to the broader market.
- 1-Year Z-score: -0.40
- Discount: -4.95%
- Distribution Yield: 7.11%
- Expense Ratio: 1.30%
- Leverage: 38.2%
- Managed Assets: $309.8 million
- Structure: Perpetual
FLC’s objective is quite simple, “provide its common shareholders with high current income.” They also have a secondary investment objective of “capital appreciation,” though preferreds and preferred funds typically fall short of this secondary goal.
To achieve the fund’s objective, they will “normally invest at least 80% of its total assets in a diversified portfolio of preferred securities and other income-producing securities, consisting of various debt securities.” They continue with, “normally invest at least 50% of its total assets in preferred securities.”
All five of the Flaherty & Crumrine funds are basically copy-pasted in terms of objective and how they seek to achieve said objective. The holdings between the funds share a significant amount of overlap.
One of the biggest impacts on these funds was the leverage utilized. Unlike other fund sponsors, F&C decided not to hedge their portfolio through swaps or shorting Treasuries. That meant they’ve felt most of the full force of rising interest rates on the cost of their leverage. Their expense ratio, including interest rate expenses, climbed to 2.60% from 1.66%. A material jump and the Fed has bumped up interest rates again since. They are also expected to raise at least another one or two times. With being fairly heavily leveraged, it also meant that declines were amplified to the downside through 2022.
Performance – Interest Rates Increases Coming To An End
Interest rates rising was a big theme of 2022. However, most of the interest rate increases should be in at this point. At least, that is what is expected. The Fed anticipates a terminal rate of over 5%. Most of the market is banking on that not happening and that they are just talking tough to keep things tighter through jawboning.
Even if it ends up at around 5%, most of the increases are already in. That should bode well for a fund such as FLC that was so negatively impacted by interest rate increases. We already saw yields of risk-free Treasuries dropping, and that helped propel FLC up quite substantially in a short period of time.
It wasn’t just the leverage that impacted FLC, but that can amplify the downside. Below we can compare FLC to iShares Preferred and Income Securities ETF (PFF). This is a non-leveraged preferred-oriented fund to provide some context of FLC’s moves. Interestingly, despite being heavily leveraged, FLC managed to keep the underperformance quite minimal on a total NAV return basis.
On the other hand, over the last ten years, FLC has outperformed PFF quite materially. Besides security selection, I believe this highlights the upside of a leveraged fund when times are good. This is also going against a much higher expense ratio between the funds. PFF’s expense ratio comes to 0.45%.
Another interesting factor that CEFs such as FLC can have over an ETF is the discount/premium mechanic that can be played. FLC has experienced trading at premiums quite regularly in the last decade. It averaged quite a narrow discount in this period at around 1%.
With the latest discount, the fund is looking much more attractive. Of course, the latest environment is quite different from the last decade too. That should be considered as some discount might be appropriate in a higher interest rate regime.
Distribution – Trims Due To Leverage Costs
The leverage in the portfolio is still providing a higher spread between the cost and what it can be invested in. That means it’s still an otherwise benefit in terms of income generation. Here is what they had to say in their last report on the subject.
The Fund uses leverage to enhance distributable income, earning the positive spread between asset yields and leverage cost. A slow increase in short-term rates would have allowed for a measured transition, but the pace and size of rate hikes have caused leverage costs to increase materially and quickly. Leverage continues to provide more distributable income compared to no leverage, but the spread has narrowed, and incremental income from leverage declined. The Fund’s goal is to pay out dividends consistent with portfolio earnings, and not maintain an artificially high dividend that is actually a return of shareholders’ capital.
However, as stated in this, the spread has narrowed. That means that all else being equal, net investment income would have declined in the last year. This is exactly what we have seen as expected with the latest annual report.
On a per-share basis, the fund had an NII of $1.50 in fiscal 2021, falling to $1.39 last year. That decline has been the contributing factor to seeing the distribution for FLC cut many times throughout 2022. It is currently at the lowest level since the fund’s launch.
Again, this is where the reduced pace of increases should help see a reduced pace of decreases. If there is a pause, then the distribution should be able to stabilize for the fund. If there is a cut, we could even see some increases in the payout.
For tax purposes, the fund has identified the entire distribution as ordinary income in both fiscal 2021 and 2022. The exact breakdown for 2022 isn’t available yet, but for 2021, 82% of the distribution was considered qualified dividend income. That can make it more tax-friendly for shareholders, and it could make it more appropriate for a taxable account.
The F&C funds are quite ‘boring’ in that they have limited turnover. This results in often having the same holdings for considerable periods of time. For FLC, turnover came to 7%. So fiscal 2022 was an even slower than usual time for changes in the portfolio as it was the lowest in the last five years.
The fund’s latest effective duration came to 3.2 years. The leverage-adjusted effective duration came to 5.4 years with an average coupon of 6.73%. Perhaps not surprisingly, the latest NAV distribution works out to 6.79%. The duration is the expected impact of how the underlying portfolio would decline for every 1% change in interest rates.
One thing that can impact this is fixed or floating rate exposure. They don’t list an exact number of floating rate exposure in the portfolio currently. However, they list that 84% of their portfolio is invested in fixed-to-float exposure. These are preferred or income securities that should begin to float after a certain date is reached.
The Fund’s focus on intermediate duration and call protection-owning fixed-reset or fixed-to-float structures with healthy backend reset spreads and avoiding most low-coupon fixed-rate securities-resulted in less overall impact from higher rates than some other segments of preferred and credit markets. For comparison, the Bloomberg US Long Credit3 total return over the same fiscal period ending November 30, 2022, was -24.7%.
While that is certainly a positive, there could be a couple of issues with trying to highlight this silver lining. For one, if a company has debt that begins to float, and they can redeem it and issue a fixed rate for less, that’s what they would likely do.
Additionally, the floating rate periods don’t kick in immediately. When glancing through the portfolio of FLC, floating rates kick in anywhere from 2023 all the way beyond 2030. Here is an example of a security where the floating portion doesn’t become effective until 2038, American International Group, Inc., 8.175% to 05/15/38 then 3ML + 4.195%, 05/15/58.
Unfortunately, that one in particular highlights how these benefits don’t come into play quickly. When the Fed was hiking rates so aggressively, the portfolio names didn’t have a chance to offset the negatives with higher income as these effects come in more gradually. So while it was mentioned as helping the overall fund, there are some caveats to consider.
Another factor in duration comes in with the credit quality of the portfolio. Naturally, investment-grade preferred and fixed-income options have a tendency to be more interest-rate sensitive. This comes from relatively longer maturities and lower yields when compared to their non-investment grade counterparts.
FLC is split fairly evenly between investment and non-investment grade holdings. The upside here is that with a higher-quality portfolio, the credit risks should be diminished. Meaning that investors should receive par value back at maturity, or if no maturity, a more reduced chance of defaulting on their obligations from the underlying issuers.
Another consistency in these funds – and most preferred-focused CEFs – is the heavy allocations to bank and insurance companies. These are often the largest issuers of preferred shares as non-cumulative perpetual preferreds help with capital ratios that are required by regulators. Basically, financials are a staple of the preferred space, and most preferred funds reflect that. That’s why those two sectors have contributed to nearly 80% of the portfolio.
As of the last report, it came in more specifically at 78.7%. This was a marginal increase from the 76.2% shown earlier in 2022.
The fund listed that they carry 215 total holdings. Despite the rather large number of holdings, the top ten of the fund make up a fairly large 32.6%.
Consistent with the low turnover creating a generally static portfolio with a static sector concentration comes the fund’s static top issuer exposure.
Some of the only changes we see are natural portfolio gyrations due to changes in valuations and not conscious decisions of buying and selling from management. We can also see the top list, as expected, dominated by financial institutions reflecting the significant overweight to that sector.
Flaherty & Crumrine has been a fairly strong fund sponsor in the preferred space. 2022 had a rapid change in the interest rate environment when the Fed started hiking rates rapidly. That caused plenty of damage to the funds, but when compared to the rest of the preferred space, the fund did relatively well. That’s even when you consider the fairly aggressive levels of leverage run by the fund.
Now with most of the rate hikes expected to be behind us, we should expect some stabilization to this fund. We’ve already seen early signs of how much the fund can run up when yields back off. Further upside could be captured if the fund can return to a narrower discount or even touch premiums, as has been a fairly common occurrence for the fund. Of course, that would likely take yields continuing to fall and the Fed cutting rates to see premiums again.