NPFD: First Year Bad; What The Future Holds

(This article was co-produced with Hoya Capital Real Estate

Introduction

The Nuveen Variable Rate Preferred & Income Fund (NYSE:NPFD) started on December 15th of 2021. Since then, NPFD has seen a price drop of over 30%! Two factors had a role in that result. First, the rapid rise in interest rates as the FOMC finally realized the inflationary trend wasn’t “temporary”, causing even floating-rate funds, especially leveraged ones, to get crushed.

The second, I believe common for new CEFs, was the opening of a wide gap between what the assets were worth (NAV) and the value investors were willing to pay for those assets in a rising interest-rate and possible recession world (price).

I did find one study that documented this phenomenon.

New funds appear on the market at a premium and move rapidly to a discount. New funds tend to get started when the existing funds are selling at premia or small discounts (Lee, Shleifer and Thaler, forthcoming). When the new funds are released, they are sold with a commission of roughly 7 percent. This means that investors have to pay $107 to obtain $100 worth of assets. When they first start to trade, the funds usually trade at a small premium. However, Weiss (1989), Peavy (1988) and Laing (1987) all document striking evidence of subsequent underperformance by these new closed-end funds. Weiss (1989), for example, found that from 1985 to 1987, 20 days after the initial offering, U.S. stock funds traded at an average premium of almost 5 percent. However, 120 days after the initial offering, these funds sold for an average discount of over 10 percent. The mean daily index-adjusted cumulative return over this period was – 25.1 percent (t-statistic of – 5.55).

Source: pubs.aeaweb.org

Nuveen Variable Rate Preferred & Income Fund review

Seeking Alpha describes this CEF as:

NPFD seeks to provide a high level of current income and total return by investing in a portfolio of variable rate preferred securities and other variable rate income producing securities. The Fund’s portfolio will be actively managed to capitalize on the relative value opportunities of different instrument types, including but not limited to securities with different variable rate coupon structures, and to invest in securities so that all, or almost all, of the Fund’s distributions of net investment income will be treated as qualified dividend income (“QDI”).

Source: seekingalpha.com NPFD

Nuveen adds this extra description about the investment policy for NPFD:

The Fund may invest up to 20% of Managed Assets in contingent capital securities or contingent convertible securities (CoCos) and up to 15% in companies located in emerging market countries but will only invest in U.S. dollar denominated securities. More than 25% of Managed Assets will be invested in securities of companies in the financial services sector.

Source: documents.nuveen.com NPFD

NPFD has $472m in Net Assets, with the following Capital structure.

The current leverage ratio is 37%, with a recent cost over 5%. Asset coverage is 309%. Investors are charge 234bps in fees, up from the 213bps listed on non-Nuveen sites, indicating their leverage costs are rising. Current fees are:

• Management: 139bps
• Other expenses: 5bps
• Leverage cost: 90bps (the leverage cost was on 64bps at the end of September: expect higher cost in 2023)

Holdings review

NPFD hold 185 assets, with 18% in Contingent Capital Securities, known as CoCos, for which Nuveen provides this definition:

CoCos are hybrid securities created by regulators after the 2007-08 global financial crisis (GFC) as a way to reduce the likelihood of government-orchestrated bailouts. Issued primarily by non-U.S. banks, CoCos are designed to automatically absorb losses, thereby helping the issuing bank satisfy Additional Tier 1 (AT1) and Tier 2 (T2) regulatory capital requirements.

Source: nuveen.com CoCos

The average leverage-adjusted duration of the portfolio is 2.7 years; not bad when interest rates are rising. The denomination breakdown is 81% Institutional assets; 19% retail. The coupon structure is allocated as such:

I have never seen any CEF with so little in straight Fixed-Rate securities. The majority of the assets are Fixed-to-Fixed rate, meaning sometime in their life, the coupon moves to a new, but fixed rate. Pure Floating-Rate securities are only 7.3%. What cannot be told without looking at each asset in detail for the 92+% where the rate will change is where they are in their rate life. In times like today, hopefully the Fixed-to-Floating have their coupon floating up.

The portfolio credit rating allocation, which Morningstar gives an average of “BBB-“, looks like this:

NPFD is clustered in the BBB (lowest investment grade) and BB (highest “junk” rating), with almost 80% of the portfolio in just those two ratings. Having just 2% not rated is very rare.

When rates are climbing, the data in the next chart becomes less important as the chance of being Called drops as rates rise.

But if rates start down next summer as some are predicting, having over 30% callable within two years is good for turnover but not necessarily rising the portfolio’s average coupon of 6.5%. The portfolio yield is just over 7% as the average price of the assets held is $91. Leverage allows investors get a higher yield.

NPFD, like most preferred stock funds, holds a majority of its assets in the Financial sector.

Since banks and other financial companies can count these assets as part of their regulatory capital, that makes them some of the largest issuers. The potential drawback is that they must be non-cumulative to be counted toward that capital base. The Issuer list is then no surprise; only #10 is not a Financial institution.

The Top 10 Issuers are 27% of the portfolio, with even the largest Citigroup, under 5% in weight, which helps reduce default risk.

Top holdings

While 30% of the portfolio is from non-US issuers, there is no currency risk as all foreign assets must be denominated in USDs.

These holdings are just under 29% of the portfolio, out of 185 assets. The bottom third provide 11% of the weight. NPFD also holds the CBOT 5 Year US Treasury Note futures (FVH3) that matures in March 2023 (-.02% weight).

Distribution review

Nuveen lists these distribution characteristics.

Something to keep an eye on is the Earnings/Distribution ratio. Currently, NPFD is not generating enough income to cover the payout. This is the worst ratio of the five CEFs Nuveen classifies in the same category. In August, when the ratio was 90%, they reduced the payout and that pushed the ratio back over 100%; it has declined every month since. Another 1cent cut would be needed to again achieve 100% coverage.

Price and NAV review

Except for the starting month, NPFD has traded at a discount most of the time.

The current 12.8% discount is below all levels outside the plunged to 14% back in the early fall. As I show later, this pattern repeats itself with other Nuveen CEFs for the past year.

Portfolio strategy

Before the December FOMC meeting, Goldman Sachs posted their economic forecast for 2023; whether they pushed up their estimates afterwards I could not find.

As most forecasters are saying, they see the peak rate being reached next summer. They see three 25bp hikes next year raising the funds rate to a peak of 5-5.25%. If correct, with is current duration of 2.7 years, investor could see a 2% drop in the average asset price held by NPFD by next summer. Unlike the consensus, Goldman Sachs does not see a recession in 2023.

The inflation forecast brings it close to the FOMC’s 2% target.

Comparing related Nuveen CEFs

Nuveen classifies the following five CEFs all as “TAXABLE FIXED INCOME – PREFERREDS AND INCOME”. This data is for the first 11 months of 2022.

So from shortly after its start, NPFD has had the lowest CAGR and highest StdDev of these CEFs that Nuveen sees as comparable. Its risk ratios are in the middle of the pack. The next set of charts shows all data back to when NPFD started in late 2021, comparing CAGRs and then price/NAV variances.

NPFD has experienced the largest price drop of the five CEFs starting from its inception date, though two others are close. The next chart shows NPFD having the largest discount to NAV of the five, though JPS is close.

Final thought

This chart shows that all five CEFs have suffered similar declines in their Net Asset Value since NPFD started. To me, that means the interest-rate environment, not NPFD’s strategy was the overwhelming driver of its disastrous maiden year. If true, it having the largest discount, would point to NPFD being the Buy choice, but waiting a few more months might be wise.