It is hardly a surprise that the biggest problem facing many American households today is the incredibly high inflation rate that is dominating the economy. There has not been a single month over the past year in which the consumer price index has not appreciated by at least 6% compared to the same month of the prior year:
As this has been going on for about eighteen months now, it has strained the budgets of many Americans to their breaking point. I discussed this in a recent blog post. As this has been raising the cost of living, people have generally been desperate to obtain new sources of income, which has ultimately resulted in a massive number of people taking on second jobs or entering the gig economy just to get the extra money that they need to survive.
Fortunately, as investors, we have the ability to put our money to work for us and generate income, so we do not need to resort to other things. One of the best ways to accomplish this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income. These funds are, admittedly, not discussed very often in the media or by investment advisors, so many people are not that familiar with them. This is a shame because these funds can offer a lot to an investor as they provide an easy way to obtain a diversified portfolio of assets that can usually deliver a higher yield than that possessed by any of the underlying securities.
In this article, we will discuss the Cohen & Steers Select Preferred and Income Fund, Inc. (NYSE:PSF), which is one fund that can be used for the generation of income. This is evident in the fact that the fund yields 9.15% today, which is more than just about anything else in the market. I have discussed this fund before, but that was a few months ago so obviously several things have changed. In particular, the fund released its annual report, so we have a more recent data source to use in our analysis. This is nice considering the turbulence that the market has experienced over the past year or so. Let us proceed onward and see if this fund could be a worthy addition to a portfolio today.
About The Fund
According to the fund’s webpage, the Cohen & Steers Select Preferred and Income Fund has the stated objective of providing its investors with a high level of current income. This is not surprising considering that the fund’s name suggests that it invests in preferred stock and other fixed-income investments. That is certainly the case, as we can see here:
Curiously, just over half of the fund is invested in bonds, which is not exactly what we would expect given the name of the fund. However, this is a very different allocation than we saw the last time that we looked at the fund. In particular, the bond and convertible securities weightings have been reduced, and the preferred stock weighting has been greatly increased. This is not really a bad thing because preferred stock typically has a higher yield than ordinary bonds. This is evident in the fact that the ICE Exchange-Listed Preferred & Hybrid Securities Index (PFF) currently yields 6.44% while the Bloomberg U.S. Aggregate Bond Index (AGG) yields 2.50% at its current level. That is an astonishingly low yield considering that money market funds are currently yielding 4.50%, but it is accurate based on the distribution payments that the index fund has made over the past twelve months. As inflation is running at 6% right now, this means that preferred securities are the only fixed-income securities providing a positive real yield.
Unfortunately, preferred stock is also more susceptible to interest-rate risk than bonds. This is because of a concept known as duration. Duration essentially refers to the period of time required for a bond to give an investor their principal back through both interest payments and the return of principal at maturity. Generally speaking, the longer the duration, the more the bond will decline in price when interest rates rise. The same concept applies to preferred stock since they are also fixed-income instruments that do not have an inherent link with the growth and prosperity of the issuing company. However, preferred stock does not have a maturity date so its duration will generally be longer than that of just about any bond.
This is something that is very important today because of the Federal Reserve’s monetary tightening regime. As everyone reading this is no doubt well aware, the nation’s central bank has been aggressively raising interest rates over the past year in an effort to reduce the high inflation that is currently plaguing the economy. Back in February 2022, the effective federal funds rate was 0.08% compared to 4.57% today:
This is one of the biggest causes of the market weakness that made headlines all throughout 2022. This certainly had an effect on both bonds and preferred stocks as the Bloomberg U.S. Aggregate Bond Index is down 13% and the ICE Exchange-Listed Preferred & Hybrid Securities Index is down 22% since the end of 2021:
For its part, the Cohen & Steers Select Preferred and Income Fund is down 33% over the same period. That is almost certain to be disheartening for potential investors, but it is not unusual for a closed-end fund to decline more than index funds during periods of market weakness. There are two reasons for this.
The first reason why this fund underperformed is that it has a higher turnover than the indices. Over the course of 2022, the Cohen & Steers Select Preferred and Income Fund had a 59.00% annual turnover. That is pretty high for a fixed-income fund, and it resulted in a drag on the portfolio’s performance. One reason for this is that it costs money to trade preferred stocks and bonds. These costs are billed directly to the shareholders, and it can be difficult for the fund’s management to consistently generate sufficient excess returns to cover these costs and still match the return of the corresponding indices. This is something that few management teams manage to accomplish consistently, and it is the biggest reason why actively-managed funds tend to underperform indices over long periods of time.
The second reason why this fund fell much more than either of the benchmark indices during the period in question is that it employs leverage. This will be discussed in more detail later in this article.
In my previous article on the fund, I noted that the Cohen & Steers Select Preferred and Income Fund had a portfolio that is primarily invested in the banking sector. That is still the case today:
This is something that may concern many readers, particularly given the recent collapse of four banks (three in the United States and one in Switzerland). However, with the possible exception of Credit Suisse Group AG (CS), those were isolated incidents under unique circ*mstances. I mentioned this in a previous blog article. In short, Silicon Valley Bank’s problems stemmed from the fact that many of its customers made the foolish decision to keep all of their money in that one bank instead of using proper risk-management practices and spreading it around to multiple banks to reduce the risk of loss in a bank run. Silicon Valley Bank itself was also rather foolish in that it was using short-term deposits to finance the purchase of long-dated bonds. It is unlikely that we will see similar problems on a widespread basis. Even if we do, this fund’s largest position to a bank is only 1.5% of the portfolio:
Thus, we can conclude that even in a worst-case scenario, the impact of any individual bank collapse will probably not have a significant impact on the portfolio as a whole. The fund thus appears to be reasonably well-diversified right now.
Overall, the biggest risk here comes from interest rates. Currently, the market is projecting that there will be another 0.25% increase in May and then the Federal Reserve will stop. In fact, the market is currently projecting that rates will be lower than they are now by September. While projecting the policies of the Federal Reserve is something of a fool’s game, many indications are that the worst is probably behind us at this point. This is especially likely to be true when we consider that there are emerging signs that the economy will soon fall into a recession.
Leverage
In the introduction to this article, I stated that closed-end funds have the ability to use certain strategies that boost their yields beyond that of any of the securities in their portfolios. One of the methods through which this is accomplished is the use of leverage. In short, the Cohen & Steers Select Preferred and Income Fund is borrowing money and then using those borrowed funds to purchase bonds and preferred stock. As long as the purchased assets have a higher yield than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. As this fund is capable of borrowing at institutional rates, which are significantly lower than retail rates, that will usually be the case.
However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts gains and losses. As mentioned earlier, this is one of the reasons why this fund has underperformed the benchmark indices to the degree that it has over the past fifteen months. As such, we want to ensure that the fund is not using too much leverage since that would expose us to too much risk. I generally do not like to see a fund’s leverage exceed a third as a percentage of its assets for this reason. Unfortunately, the Cohen & Steers Select Preferred and Income Fund currently has levered assets comprising 36.85% of its portfolio, so it is above this cutoff. With that said, it is not very far above it and the fund is invested in fixed-income securities, which are generally low-risk assets when compared to common stocks. Thus, it probably is not exposing us to excessive risk through its leverage, but we also want to ensure that it does not start taking on more debt.
Distribution Analysis
As stated earlier in this article, the primary objective of the Cohen & Steers Select Preferred and Income Fund is to provide its investors with a high level of current income. In order to achieve this objective, the fund purchases bonds, preferred stock, and other assets that primarily deliver a return through direct payments made to investors. It then applies a layer of leverage to artificially increase the yield of the portfolio. As such, we can probably assume that the fund will pay out a very high yield itself. This is certainly the case as the fund currently pays out a monthly distribution of $0.1350 per share ($1.62 per share annually), which gives the fund a 9.15% yield at the current price. Unfortunately, the fund has not always been consistent about this distribution and has cut it twice over its history:
This is a much better track record than most fixed-income funds, whose distributions typically vary based on interest rates. However, the fact that the fund has cut the distribution twice since 2020 might still be something of a turn-off to those investors that are looking for a safe and secure source of income to use to pay their bills and finance their lifestyles. As is always the case though, anyone purchasing the shares today does not have to worry about the fund’s history since new money will receive the current distribution at the current yield. As such, the most important thing today is the fund’s ability to maintain its current distribution going forward.
Fortunately, we have a very recent document that we can consult for our analysis. The fund’s most recent financial report corresponds to the full-year period that ended on December 31, 2022. This is a much newer report than we had available the last time that we looked at this fund, which is nice because it should give us a very good idea of how well the fund handled the series of interest rate hikes that significantly changed the market environment for fixed-income securities over the course of the year. During the full-year period, the Cohen & Steers Select Preferred and Income Fund received $17,281,836 in interest and $4,711,444 in dividends from the assets in its portfolio. This gives the fund a total investment income of $21,993,280 over the period. The fund paid its expenses out of this amount, which left it with $15,171,396 available for the shareholders. This was, unfortunately, not enough to cover the $19,483,147 that the fund actually paid out in distributions over the period, although it did manage to get pretty close. It may still be concerning at first glance though as the fund did not have sufficient net investment income to completely cover its distributions.
However, there are other methods via which the fund can obtain the money that is needed to cover the distribution. For example, it might have capital gains. As might be expected considering the fixed-income environment in 2022, the fund failed miserably at this task over the course of the year. The fund reported net realized losses of $13,118,248 and had another $48,856,874 million net unrealized losses. Overall, the fund’s assets declined by $66,210,025 over the course of the year after accounting for all inflows and outflows. Thus, the fund clearly failed to cover its distribution in 2022, which is concerning. In addition, the fund’s assets were considerably lower at the end of 2022 than they were at the start of 2021, so the fund lost money over the two-year period. This is a clear sign that it may not be able to maintain its distribution going forward. However, the worst of the effects of the monetary tightening is probably behind us, as already mentioned. The fixed-income market has actually been rather bullish so far in 2023 so this might allow the fund to begin realizing some capital gains. The fund does not need substantial capital gains to cover the distribution since its net investment income alone is pretty close to doing so. I would not be surprised to see a distribution cut in the near future if conditions deteriorate, but this fund might be able to maintain the distribution going forward.
Valuation
It is always critical that we do not overpay for any assets that are in our portfolios. This is because overpaying for any asset is a surefire way to generate a suboptimal return on those assets. In the case of a closed-end fund like the Cohen & Steers Select Preferred and Income Fund, the usual way to value it is by looking at the fund’s net asset value. The net asset value of the fund is the total current market value of all the fund’s assets minus any outstanding debt. It is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.
Ideally, we want to purchase shares of a fund when we can buy them at a price that is less than the net asset value. This is because such a scenario implies that we are acquiring the fund’s assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of March 29, 2023 (the most recent date for which data is currently available), the Cohen & Steers Select Preferred and Income Fund had a net asset value of $18.38 per share but the shares only trade for $17.85 a piece. This gives the fund’s shares a 2.88% discount to the net asset value at the current price. This is not nearly as attractive as the 4.15% discount that the shares have possessed on average over the past month, so it is possible that a more attractive price will emerge in the near future. However, the current price is not a terrible one to pay for the fund.
Conclusion
In conclusion, the Cohen & Steers Select Preferred and Income Fund, Inc. is a reasonable way to get an income today. The fund has admittedly underperformed the indices over the past several months, but it appears that the worst is probably behind it and the Cohen & Steers Select Preferred and Income Fund, Inc. has a much higher yield than the indices. The fact that the fund is heavily invested in bank preferred stocks is probably not as big of a risk as might be expected. The current distribution is probably sustainable, but there are some very valid reasons to be concerned and this is something that we will need to keep a close eye on. Finally, the fund is trading at a reasonable price today. Overall, the Cohen & Steers Select Preferred and Income Fund, Inc. appears to be a reasonable option for purchase today.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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