Corporate bonds

HPF: CEF Preferred Stock and Corporate Bonds (NYSE: HPF)

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Thesis

John Hancock Preferred Income Fund II (HPF) is a closed-end fund focused on preferred shares and preferred convertible securities. The primary objective of the fund is a high level of income, followed by preservation of capital. The vehicle aims to invest at least 50% of the fund’s holdings in higher quality securities and currently has banks and utilities as its highest exposures. The fund has a fairly low Sharpe ratio of 0.41 (5-year measurement window) and a high standard deviation of 15.78. On a total return basis, the fund has a modest 3-year total return of 4.71% and a 5-year total return of 6.27%. The fund currently has a dividend yield of 7.66% and a 61% allocation to preferred securities, with the remainder invested in corporate bonds. HPF has very high sensitivity to credit spreads, having seen a decade of yields wipe out in the Covid market meltdown. After trading at a premium to NAV in 2021 due to investors clamoring for yield, the fund is finally trading flat to NAV, but on a downward price trend due to the fed contraction. With a high fee of 2.35%, the fund has tracked the benchmark in the preferred space for the past five years, namely Flaherty & Crumrine Preferred And Income Securities Fund Inc (FFC). With a modest return profile, high fees and cyclical behavior, the fund can only be bought if credit spreads widen substantially. We expect rising rates this year to continue to negatively affect HPF and expect stable total return performance. If you are a fund holder, we would cut the allocation in half, while a retail investor looking to allocate cash to the sector would do well to only buy after a further -7% drop in market price of the fund. We therefore rate it a Hold as it is.

Assets

The fund currently holds just over 60% of its holdings in preferred shares:

asset mix

Asset mix (Fund Fact Sheet)

The current concentration of preferred shares is skewed towards banks and energy companies:

Top 10 issuers

Main titles (fact sheet)

The top 10 holdings represent approximately 42% of the portfolio and over 70% of the preferred securities component. The manager is quite active with a portfolio turnover above 30% as reported by Morningstar:

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Portfolio turnover (The morning star)

The fund is overweight financials and utilities in its preferred share portfolio:

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Asset Allocation (SEC Report)

We can see from the recent SEC filing above the industry allocation that the vehicle is currently pursuing through its holdings.

Performance

On a 10-year basis, the fund doubled a notional investor’s initial investment but underperformed the standard fund in the space, namely Flaherty & Crumrine Preferred and Income Securities Fund Inc:

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Total return over 10 years (Looking for Alpha)

The very sharp drop during the Covid crisis, which led to the complete erasure of a decade of total returns, is also concerning.

The fund performed poorly during the early stages of the last Fed tightening cycle:

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HPF performance 2013-2016 (Looking for Alpha)

Premium/Rebate to NAV

The fund exhibits an annual net asset value drop of -0.8%, measured over the past decade:

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Yield NAV 10 years (Cef Connect)

An annual drop means the fund is not increasing net asset value but destroying long-term shareholder value. For this metric, we look for long-term NAV stability when analyzing buy-and-hold vehicles. Good managers tend to ensure that the net asset value is stable over a longer time horizon by trading the underlying instruments and managing distributions accordingly.

HPF traded at a discount to NAV during the last tightening cycle of 2013-2015:

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Premium/Rebate to NAV (The morning star)

In the chart above, the blue area indicates a premium to NAV while the green indicates a discount to NAV. In 2021, as investors clamored for yield, the fund traded at a significant premium to net asset value. This premium is now compressing as the Fed raises rates.

Distributions

The fund tends to cover over 90% of its distributions from interest income:

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Distributions – Article 19a (fund website)

While the past month has been characterized by a large return of capital (i.e. a drop in net asset value), in the longer term we can notice that investment income represents 95% of the distribution to shareholders. This aligns well with the historical decline in net asset value that we have seen over the past decade, which stands at -0.8% per year.

Conclusion

The fund is a good mix of preferred stocks and high yield bonds, but shows modest total returns for the level of risk taken. We’ve seen how the Covid pandemic wiped out a decade of total returns before the market rebounded, but that says a lot about the credit risk the fund faces given its 33% leverage. The fund has very high management fees for the returns it has produced and it does not compare well to the norm in the space, namely Flaherty & Crumrine Preferred and Income Securities Fund Inc. We expect that rising rates this year continue to negatively affect the HPF and forecast flat total return performance. We therefore rate it a Hold as it is.