Co-authored by Treading Softly
Ever wandered through a bustling mall on Black Friday and scoffed at the crazy discounts, certain that there must be a catch?
“I don’t want that large-screen TV – It’s 50% off. Something must be wrong with it!”
“I don’t want that oven. It’s 25% off, and that must mean that it’s low quality!”
“Other people are willing to pay full price for other products, I’m not gonna buy this on a sale.”
Sounds ridiculous, right? It seems that these days, everyone is looking for a deal. Everyone is looking for a sale. People are cutting coupons and trying to pinch pennies where they can. Yet, when it comes to the market, investors so often have a completely other mindset. The more expensive it is, the better they think it is. They’re not willing to buy things when they’re out of favor or on sale. They’re only willing to buy things sometimes at the highest premiums they’ve ever seen. This is a common reason why the average investor so grossly underperforms a simple market-wide ETF. While many people claim that they espouse the view of “capital preservation” or “buying low and selling high,” few successfully perform that task, and therefore, buying a passive market-wide ETF like the SPY provides them with better returns because it removes their emotions from the equation.
This past year has been absolutely brutal for the fixed-income sector with rapidly rising rates, and thus, investors have fled the sector because it was getting beaten up. Now, many of us are afraid to return to the sector because it’s on sale. So, just like the Black Friday shopper above, they see the price tag and instead of buying it at a discount, they simply keep on walking, worried that it must be wrong for some reason.
Today, I want to look at a fund that allows you to gain exposure to a sector that’s vastly on sale. So that way, you could earn some outstanding income from it.
Let’s dive in.
A Newly Combined Fund
Nuveen Preferred & Income Opportunities Fund (NYSE:JPC), yielding 8.5%, is a CEF (Closed-End Fund) that recently saw a merger combining three Nuveen funds: JPS, JPT, and JPC. The fund invests primarily in preferred equity and other fixed-income investments. We came into ownership of JPC through JPS, a move that led to a slight increase in our dividends. Then, with the latest announcement, JPC raised its dividend 8% to $0.0475/month.
This is a welcome change from the recent trend, which has been a series of dividend cuts. The phrase “dividend cut” strikes terror into the heart of income investors. I frequently say that dividend cuts from closed-end funds are the least concerning type of cut. Why?
When we analyze investments, we are often looking at businesses that produce something or provide a service. They build some kind of infrastructure, attract customers, and manage their costs and balance sheets. Over time, a “good” company will develop a larger infrastructure, allowing it to expand its customers and make higher profits. We expect that companies will generally see higher profits year after year. When they start seeing their profits decline, we start seeing dividend cuts.
In this sense, a dividend cut is often a reflection that something is “wrong” with the core strategy of the business. Maybe their product isn’t in demand anymore, maybe they were overextended on their balance sheet, or maybe they are doing a poor job executing their business plan. We then have to figure out if whatever is wrong can be fixed, or if the business is so broken that it is no longer worth operating at all.
CEFs are different. They don’t build infrastructure, and they don’t develop anything. They take the capital they have and invest it in a particular sector or strategy. The distributions that a CEF pays will represent somewhere around 100% of the total returns of the CEF’s investment portfolio. The reason is that they are required by tax law to distribute substantially all of their income and capital gains. Therefore, it is unreasonable to expect a CEF to “grow” year after year because whatever gains they have will be distributed to shareholders. We also know that returns from the stock market are not consistent. Here is SPY’s annual returns since 1994: Source
Big years, modest years, and years of losses. This is what all investors have to face.
To provide stability, CEFs will often have a “managed dividend policy” where they set the dividend at a level that management expects will match the mid to long-term total returns of the portfolio. It will sometimes be “underpaying” and other times “overpaying” what the portfolio returned in a particular year.
In the long run, the total return investors receive from a CEF will approach the total return of the underlying portfolio through some combination of NAV and dividends. If the manager decides to overpay in a down year, that will reduce NAV. If the manager underpays during an up year, NAV will increase. Whether the manager decides to have an aggressive dividend policy or a more conservative one, it doesn’t make a substantial difference in the total return. Managers who are quick to reduce the dividend will have funds that maintain NAV better than managers who are willing to overpay.
Therefore, the primary question investors should ask themselves when buying any CEF is whether they want more exposure to the sector. Second, they should ask whether the manager has a history of outperforming other options in their sector.
JPC invests in preferred equity, primarily institutional preferred, with a $1,000 par value. The bulk of its holdings are banks and insurance companies. Source
We have frequently discussed the virtues of preferred and the great opportunity in preferred today as prices have declined primarily due to higher interest rates. When interest rates go up, the price of all fixed-income investments comes down. When interest rates
