Flaherty & Crumrine DFP Fund: The Ugly Side Of Higher Rates

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Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on August 15th, 2022.

What we see in Flaherty & Crumrine Dynamic Preferred and Income Fund (NYSE:DFP) and its sister funds isn’t entirely unexpected. Higher interest rates are leading to higher interest expenses on these leveraged funds, which has meant a cut in the payouts.

While most of today’s discussion can be applied across the board for the F&C funds, I’ll focus on DFP as that’s my current F&C holding. We noted that further trims could be necessary in the last update on DFP.

NII coverage came in at 93.6% for those six months. Based on the current annualized distribution of $1.9404 and shares outstanding of 19,372,836 – that would mean roughly $37.6 million in expected distributions paid out to shareholders. That’s still below the annualized NII figure if we extrapolate out the NII shown above.

That puts us in the situation of still needing to trim from here unless earnings have increased since this update. That is certainly a possibility as well. However, they aren’t usually a sponsor to aggressively turn over their portfolio. Turnover for those six months came to 6%, right in line with last year’s 12% turnover.

Indeed, we are seeing that playing out now as the Fed hikes. The fund has cut the distribution from $0.1617 per month at the end of 2021 to $0.13 monthly. That’s a decline of 19.6%. Since the fund began, we notice several changes reflecting the different interest rate environments. For DFP, it has been mostly a 0% rate environment.

DFP Distribution History

DFP Distribution History (CEFConnect)

DFP is a relatively newer fund, so it looks more stable over the last decade. Looking at Flaherty & Crumrine Preferred Income Fund (PFD) can take us back further. That fund was incepted in early 1991.

DFP Distribution History

DFP Distribution History (CEFConnect)

What’s Going On With The Distribution?

Flaherty & Crumrine focuses on paying out income only from their funds. That means an adjustment is always on the table, whether up or down. We saw the benefit of rates being slashed in the COVID pandemic. This has now been reversed, with rates heading higher as the Fed works to halt inflation.

Besides what would be presumed to be better positioning in the funds, I believe this could have helped explain why this group tends to outperform its peers. We’ve discussed in our last preferred update that F&C continues to rank at the top for longer-term performance. Though this can vary over shorter periods of time.

If they aren’t paying out gains (which we know they have a low turnover), then that leaves more capital to stay invested in income-generating positions.

A fresh look at the last five-year period shows that John Hancock Preferred Income II (HPF) has inched out ahead. Still, DFP leads the way ahead of these other preferred funds. (I just took a random sampling of preferred funds that have at least a five-year history.)

DFP and other preferred funds NAV and return

Ycharts

More interesting here is that the actual income the fund generated in its last semi-annual report rose. The six-month figure here can be compared with the previous fiscal year shown below. This can also be compared with the $17,746,001 they reported last year.

DFP Financials

DFP Semi-Annual Report (Flaherty & Crumrine)

However, I would note here that the funds utilize an at-the-market offering. That means shares are being sold throughout the market trading day when the funds are at a premium. The dividend reinvestment program also allows for shares to be created when shares are at a premium.

That took shares outstanding from 19,372,836 on May 31st, 2021, to 20,509,836 on May 31st, 2022 – an increase of 5.87%.

The total distributions paid out in this latest period also only reflect what would be a minor increase. This increase was due to the increased number of shares overall. The full amount of cuts isn’t being priced in yet, either.

If we multiply by the latest monthly distribution rate, we reach a forward annualized amount of $1.56. Taking that and multiplying by the latest reported outstanding shares, we would arrive at $31,995,344. That’s well below what was paid out in the prior year.

Therefore, putting all of this together, we can see that despite NII increasing, the share count is also increasing. That sort of masks what is going on underneath.

The financial highlights of these posted reports from CEFs give us a better clue of what’s going on. In that case, we see the NII per share for the six months ended May 2021 at $0.93. For the six months ended May 2022, we have declined to $0.90.

DFP Operational metrics

DFP Semi-Annual Report (Flaherty & Crumrine (highlights from author))

That only works out to what would look like a $0.05 hit from the fiscal year prior. However, this was only through the period that ended in May 2022. The rates have only increased since. What we can also see from the financial highlights is just how high the expense ratio went in 2019. That was effectively the last “peak” in the previous rate hike cycle. So we can see we have more expenses to eat yet going forward.

Total outstanding debt at the end of May 31st, 2021, was $261.7 million. That cost the fund $202.25k in expenses for those six months being reported. They have increased the leverage for the same period ending 2022. We now have $276.3 million, which cost the fund $361.541k in interest expenses this year. That was a ~5.6% increase in total outstanding debt with a cost increase of nearly 79%.

What Could Reverse This Trend?

Of course, the next question to answer is what could make this trend stop. First of all, I think that if the Fed does slow or pause rate hikes, we could be seeing the worst of it playing out now. I wouldn’t say that we don’t see a few more cuts, but we should be getting close.

Secondly, 90% of the portfolio has fixed-to-float exposure. These kick in over the next several years and could be one way that yields increase on their underlying portfolio. That would happen even if they aren’t turning over their portfolio aggressively to look for those higher yielders. Here’s a look at a small sample of their holdings to give us an idea of these terms.

DFP Holdings

DFP Holdings (Flaherty & Crumrine)

We can see that these floating rates can kick in anywhere from 2023 to 2031 for these specific holdings.

A third option to see this trend reverse is probably more detrimental for portfolios overall. That will be if the Fed has to start cutting rates because we are heading into a deep recession (more than this technical recession that we have experienced.) That would mean leverage expenses once again start going down, which is precisely what we experienced in the COVID crash. That’s when the F&C funds raised their payouts last time.

Price Action And Valuation This Year

The underlying holdings are turning lower, causing the price of these funds to go lower, a side effect of higher rates. Despite the significant rally we’ve seen in the overall market and fixed-income space, DFP is still down meaningfully for the year.

DFP Total Return Price
DFP Total Return Price data by YCharts

The fund’s premium has come down since our original update, making it fairly attractive too. That would be in combination with the lower price due to the higher interest rates. Now the question would become how much of the rates are already priced in. We are only slightly below the longer-term discount average.

DFP Discount or Premium to NAV
DFP Discount or Premium to NAV data by YCharts

That would suggest that despite the distribution trims this year, it doesn’t seem to be weighing on the shares too heavily. The overwhelming impact on the fund has been its underlying portfolio.

Conclusion

The simple answer to what is happening is; that rates are rising, leading to higher leverage expenses for the fund. The higher income through more outstanding shares hasn’t been enough to offset this.

Admittedly, I thought that DFP was fairly attractive given the declines that we saw when I last touched on DFP. For some insight, it was posted in November of last year and things have changed rapidly since that update.

It quickly became apparent that the Fed would have to be even more aggressive than originally thought or projected. I don’t try to predict the way interest rates are going, so I was taking the Fed at face value.

That meant I was way too early in what I thought was an attractive fund. Though I would continue to say that the price matters a bit less for a longer-term income investor. After recovering from the lows, I think DFP is still quite attractive, especially now that the premium has come down a bit. That has put the valuation closer to its longer running average. For a truly good deal, we could wait for another period of a ~5% discount. I believe that would present a strong buying opportunity.

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