Preferred Stock for the Conservative Investor

Every preferred stock investor has needs that drive his or her investment purchases.

These needs primarily revolve around a certain level of income to sustain a desired lifestyle. Such a goal requires earning a certain monthly income level, with maximum safety, and almost always leads me back to a certain category of preferred stocks.

When high, or even extreme, safety is the primary desire, consider the safest preferred stocks outstanding. These are the preferred stocks issued by closed-end funds (CEFs). There are no other preferred stocks issued that are rated higher by the ratings agencies — even preferreds issued by utilities are not rated as safe as the CEF preferreds.

The preferreds available for really high safety are mostly issued by the Gabelli family of closed-end funds. The Gabelli family includes the Bancroft Fund (AMEX:BCV) and the Ellsworth Growth and Income Fund (AMEX:ECF).

In addition, Allianz has two closed-end fund preferreds outstanding which are of very high quality. In total, there are 24 preferred issues outstanding from these issuers. All of these issues are “perpetual” preferreds, meaning they have no set maturity date and are cumulative with respect to dividends.

CEFs use the proceeds from preferred stock issuance for “leverage.” Indeed, leverage is used by the funds to invest in stocks and bonds to pursue heightened returns compared to the cost of the leverage. Such leverage can come in the form of debt issuance or preferred stock. These debt or preferred stock issues are termed “senior securities,” which have a higher priority for repayment than the common shares that the CEF has outstanding. In a bankruptcy, the holders of the senior securities have first claim on the fund’s assets.

As investors, we are fortunate that the use of this leverage by closed-end funds is regulated by law. In the case of preferred stock, the fund must maintain an asset coverage ratio of at least 200%. This means that for each $1 of preferred stock outstanding, a fund must have $2 of assets.

The CEFs mentioned above are all composed of stocks and bonds, which are mainly Level 1 assets. Level 1 assets can be valued by direct observation, which means they typically trade on a stock exchange. Because the funds primarily hold Level 1 assets, we can be assured that the fund assets are valued easily and correctly.

In the case of closed end-funds, we are not necessarily concerned with the performance history of the issuing CEF, but instead we desire to see the “asset coverage ratio” at a high level. We want to be able to sleep well at night.

While the prices of all preferred stocks are quite high right now, there are a couple CEF preferreds that I believe currently are relative bargains for conservative investors.

The AllianzGI Convertible and Income Fund 5.62% (NYSE:NCV-A) cumulative preferred stock is now trading in the $24.61 area to give it a current yield of 5.71%. This issue is rated AAA by Fitch. Further information on this issue can be found here. The issue had an excellent asset coverage ratio of 353% when it last reported.

AllianzGI Convertible and Income Fund II has a 5.50% coupon preferred outstanding (NYSE:NCZ-A) that is trading in the $24.04 area to offer a current yield of 5.73%  With a rating of AAA from Fitch, it a very safe issue. This CEF issue has an asset coverage ratio of 368% at last report. Further information on the issue can be read here.

 Most of the CEF preferreds from Gabelli are now trading with current yields in the 5.2% to 5.3% range, indicating that the AllianzGI issues are relatively underpriced and present a good opportunity to purchase the safety of a AAA-rated preferred stock issue.

We need to mention that all these issues contain a fair amount of interest rate risk. Thus, if interest rates rise, the issues may fall in price. On a long-term basis, the high level of safety should serve the very conservative investor well, even with movements in share price.

The above should not be construed as specific advice to purchase these securities. Each individual investor needs to determine his or her financial goals and risk tolerance before making an investment decision.

Disclosure: I own both of the AllianzGI issues referenced above, as well as some Gabelli CEF preferreds.