What to Buy: John Hancock Premium Dividend Fund (NYSE: PDT)

Why to Buy Now: Like other income-oriented securities, closed-end funds (CEF) suffered a mass exodus in May and June, as traders moved to the sidelines in anticipation of an eventual end to the Federal Reserve’s extraordinary easing. But these moves proved premature, as the Fed recently backed away from some of its more hawkish statements.

That’s left PDT trading at a 10.3 percent discount to its net asset value, while offering an enticing distribution rate of 6.9 percent.

The fund’s seasoned management team tends to allocate roughly 30 percent to 40 percent of the portfolio to equities and 60 percent to 70 percent to preferred stock, with the utilities and financial sectors as its main focus.

Management does use substantial leverage to boost its payout and returns, but it’s done so while delivering excellent long-term returns. Equally important and in contrast to many of its peers, PDT’s monthly distribution typically consists of net investment income and the occasional long-term capital gain, without any destructive returns of capital.

Finally, it’s worth noting that PDT managed to boost its distribution twice at the height of the 2008-09 downturn.

New shareholders are automatically enrolled in the fund’s dividend reinvestment program (DRIP). If you’d prefer to receive the distribution in cash, then you’ll need to opt out of the DRIP.

Buy John Hancock Premium Dividend Fund below 13.75. CEFs often have relatively low trading volumes. PDT’s average trading volume over the past three months was around 170,000 shares per day. As such, be sure to use a buy limit near the market price to avoid overpaying for shares.

Ari: Before we start detailing what attracted us to this month’s pick, John Hancock Premium Dividend Fund (NYSE: PDT), there’s quite a bit to explain with regard to closed-end funds (CEF).

Khoa: Great. Go ahead and bore everyone, as per usual.

Ari: Well, if your eyes start to glaze over, just remember that the payoff is a security that yields almost 7 percent. But feel free to interject if my rambling gets to be too much.

Khoa: Oh, I will.

Ari: Alright then, let’s get on with the slog:

Although closed-end funds have been around for almost a century, they still occupy an obscure corner of the financial markets. But lately yield-starved investors have started to notice their sizable payouts.

Closed-end funds (CEF) are investment companies that actively manage pools of assets in a manner similar to mutual funds, but trade on the open market, just like exchange-traded funds (ETF).

Khoa: Okay, so PDT is basically like an actively managed mutual fund, but it just happens to trade on an exchange. That’s easy enough. Tell us more about its portfolio.

Ari: Income-oriented investors will appreciate this fund’s mandate, which requires it to deliver high current income along with modest capital gains by investing at least 80 percent of assets in dividend-producing securities and at least 25 percent of assets in the utilities sector.

To that end, the portfolio tends to be divided between equities and preferred stock. A majority of the portfolio is typically allocated to preferred stock, with preferreds accounting for 61.5 percent of assets at the end of April versus 35.8 percent for equities.

I reviewed the portfolio’s holdings over the past 10 years, and preferreds have been as high as 76 percent of assets (in April 2009), while equities have been as high as 40 percent of assets (in October 2006).

Preferred stock is a hybrid security of debt and equity. It’s higher in a firm’s capital structure than equity, so holders of preferred stock are more likely to be made whole in the event of a bankruptcy.

Preferreds pay a regular dividend, and shares tend to offer a greater yield than equity. They also take precedence over equity when it comes to payment of dividends, though their payouts can also be suspended. While cumulative preferreds will eventually pay any missed dividends in arrears, a non-cumulative preferred can miss a payment without ever making it up.

Many preferreds have a call provision that enables a company to retire them after a certain period of time and within a certain price range.

In terms of sectors, the fund’s mandate means it obviously has a bias toward utilities, which recently accounted for 48.7 percent of assets. And the fact that a majority of preferred stock is issued by financial institutions means that this fund has a sizable allocation to that sector as well, at 35 percent of assets.

However, the financial sector’s dominance of preferred stock issuance could soon change, as the Federal Reserve just ruled that it will no longer allow bank holding companies to count trust preferreds toward Tier 1 capital, though it will grandfather existing preferreds for smaller institutions.

Over the past five years, utilities have taken up as much as 61 percent of assets, while financials are currently at their highest weighting over that period.

Beyond that, the fund also has a modest slug of assets invested in securities from the energy and telecommunications industries, recently at 4.9 percent and 6.7 percent of assets, respectively.

The seasoned management team, one of whom has been with the fund for over 18 years, tends to invest with conviction. In fact, portfolio turnover has averaged just 14 percent over the past five years.

Khoa: Given the fact that this fund invests heavily in preferred stock, are you concerned that we appear to be shifting from a historically low interest rate environment to a rising-rate environment?

Ari: That’s certainly a risk. As we wrote in the last issue of Big Yield Hunting, many income-oriented securities suffered a rapid exodus in May and June, as investors feared the Federal Reserve could soon curtail its easing. But there are two separate facets of the Fed’s monetary policy and both of them will be phased out at different times.

The market was largely fixated on the Fed’s $85 billion per month bond-purchasing program. This is what is otherwise known as quantitative easing, and it’s designed to hold down long-term rates, such as those that influence mortgage rates.

Bernanke had said that the Fed believes economic data are trending in a direction where they could begin winding down this program as early as this fall. But he’s also acknowledged that the Fed’s outlook tends to be rosier than his private sector peers. And more recently, he’s stressed that the Fed continues to believe that the US economy will need “highly accommodative monetary policy for the foreseeable future.”

So for now, I believe that the beginning of the end for this program might not occur until some months later. But even if it does occur, it will likely be incremental, perhaps even halting, and if the economy sputters again, it could also revert to full easing mode.

And the federal funds rate, which the Fed uses to influence short-term rates, is likely to remain at current levels for at least the next two years.

Even so, when the market tries to anticipate the Fed’s moves, anxious traders can essentially force rates higher before the central bank has even acted. We’ve seen that happen over the past two months. Fortunately, financial market conditions have begun to ease again, now that Bernanke has provided greater clarity since his earlier remarks.

Still, we’ll need to monitor how management decides to navigate this environment. They have been hedging their exposure to rising rates since August 2011, when they initiated the first of two interest rate swaps. They added a second swap a year later. Each swap has a five-year duration, and together they cover a notional value of $164 million, or about 23 percent of the portfolio’s allocation to preferreds.

We could get into the mechanics of how this hedge works, but I don’t want everyone’s head to explode. Suffice it to say, that management is clearly looking for a way to protect its portfolio from rising rates, though so far that’s been a modestly losing bet, as rates have remained near historic lows.

I also reviewed the fund’s performance during the Fed’s last tightening cycle, which ran from June 2004 though September 2007. Over that period, PDT still managed to gain 4.5 percent annually on a net asset value (NAV) basis, 0.9 percent annually on a price basis, and 7.2 percent annually on a price basis with the reinvestment of distributions.

So a rising-rate environment clearly poses a challenge, though the fund should be able to hold its value, while continuing to pay its distribution.

Aside from rates, of course, I’m also concerned that yield-starved investors have pushed both utilities and preferreds higher and higher, without regard to price. But I trust the management team’s value-oriented approach to keep them from chasing the high flyers.

Finally, it remains to be seen how the aforementioned change in rules regarding Tier 1 capital will affect the preferred market. It could reduce supply considerably even as demand remains strong, which would presumably be good for the fund. On the other hand, it could also compel larger bank holding companies, whose existing preferreds aren’t grandfathered in under the new rule, to retire preferreds sooner.

Khoa: What about the fund’s distribution? It’s pretty high, but I also see a number of other CEFs that offer even higher distribution rates.

Ari: I’ve looked at a huge number of CEFs over the past month, and virtually all of the ones that have distribution rates higher than PDT engage in practices that erode shareholder value.

Income investors must be mindful of the source of a CEF’s distribution, as well as the fact that many funds use leverage to boost their payouts.

A fund’s distribution can consist of net investment income, short- and long-term capital gains, and return of capital. The latter detail is particularly important, as many CEFs entice investors with high distributions that can only be maintained via regular destructive returns of capital, a Ponzi-like scenario where investors are basically getting their own money back net of management fees.

However, not all returns of capital are bad. For instance, when a return of capital is based on unrealized capital gains and is, therefore, paid out from a fund’s cash balance, that typically means management is attempting to let its winners run, rather than liquidate them to meet its short-term obligations.

To determine whether a return of capital was destructive, compare a fund’s calendar-year return on NAV to its total distribution. If the fund’s year-end NAV net of the distribution is lower than where it began the year, then the return of capital was likely destructive.

Time and time again, I found that CEFs that include at least some equity among their investments and have a distribution rate higher than 7 percent are likely funding their distributions via destructive returns of capital.

But even the occasional destructive return of capital is permissible as long as management doesn’t make a habit out of it. They may have erred in projecting their payouts or the market may have suffered a short-term dislocation that eroded a portion of the payout.

And if the fund trades at a discount to NAV, then even a destructive return of capital can enhance returns if investors participate in a fund’s distribution reinvestment program. Regardless of whether they’re good or bad, returns of capital are not taxable and serve to reduce an investor’s cost basis.

The good news is that PDT’s monthly distribution (currently $0.0755, for a distribution rate of 6.9 percent) is typically paid entirely from net investment income. At the end of April, the fund even had a reserve of $0.064 in undistributed net investment income.

In reviewing the history of this distribution, I noticed that while portions of some of the distributions from 2008 through 2010 were initially characterized as return of capital, these amounts were ultimately attributed to realized long-term capital gains in subsequent reporting.

That gets back to what I mentioned earlier: When a CEF smooths its distribution to provide shareholders with a predictable monthly payout, in the short term, net investment income and realized capital gains may not be sufficient to fully fund the distribution, even if they end up doing so later.

Also of note is the fact that the fund actually boosted its monthly distribution twice at the height of the 2008-09 downturn, taking the payout from $0.048 in late 2008 to $0.065 by May 2009, an increase of 35.4 percent.

Khoa: What about leverage?

Ari: The fund does use leverage to enhance both its payout and its returns. It has a credit facility agreement that allows it to borrow up to 33.3 percent of managed assets, and it’s currently utilizing this facility at that threshold.

While leverage works great on the upside, it can also magnify losses on the downside. But management has earned our trust in deploying this extra capital shrewdly.

In the bear market year of 2008, for example, the fund’s net asset value fell just 21.5 percent versus 37 percent for the broad market.

And over the long term, PDT has generated outstanding returns, with its NAV gaining 10.4 percent annually over the past 10 years versus a 7.6 percent annual return for the broad market. And over the trailing five-year period, the fund returned 16.4 percent annually versus an 8.5 percent annual rise for the S&P 500.

The broad market isn’t ordinarily an appropriate benchmark for a fund that typically allocates just 30 percent to 40 percent to equities, but I thought the comparison was worthwhile.

Of course, both utilities and preferreds have had quite a run during this time period, and at some point they could falter. So while one shouldn’t necessarily expect these kinds of returns in the future, it does show what’s possible when the fund has the wind at its back.

Khoa: You’ve mentioned the fund’s performance in terms of price and NAV. What does that mean exactly? 

Ari: So here’s one of the most compelling aspects about investing in CEFs: Many trade at levels that offer the opportunity to buy a slice of assets at a discount to their market value.

Khoa: Well, I am a value-conscious consumer.

Ari: Indeed, so pay attention. Unlike ETFs, whose structure generally keeps net asset values (NAV) closely aligned with market prices, CEFs don’t have such a structure, which means traders can push share prices above or below NAV.

But bargain hunters should also be aware that many CEFs trade at persistent discounts to NAV, so it’s important to compare a fund’s current discount to its longer-term discount, such as over the trailing three-year period, to determine whether it’s truly undervalued. And, of course, it’s best to avoid CEFs that trade at premiums to NAV.

Khoa: How does PDT stack up in this department?

Ari: At present, it trades at a 10.3 percent discount to its NAV, which is near its three-year low, as far as discounts go. Its average discount over that span has been 3.9 percent, so that suggests the current discount could narrow over time and that the fund is a value play at current prices.

Like dividend stocks and other income securities, PDT’s share price took a hit following the Fed’s initial comments about an end to easing. In fact, its share price actually fell much harder than the value of its underlying portfolio. Since then, its price has begun to climb again, but the fund still trades at a deep value.

Since you can’t dine out on returns on NAV, investors should be aware that over the long term, PDT’s return on NAV has actually exceeded its return on a price basis, by six-tenths of a percentage point over the past 10 years.

CEFs occasionally initiate tender offers to help narrow persistent discounts to NAV. PDT has made such offers in the past, though its last tender offer was in 2008, when it offered to buy back shares at 98 percent of NAV.

PDT does periodically trade at a premium, with the highest premium during the past three years almost 7.6 percent above NAV.

In those instances, investors should be aware of the fund’s dividend reinvestment program (DRIP).

First, it’s important to note that it appears that new investors are automatically enrolled in this program, so if you prefer to receive the distribution as cash, you’ll have to opt out of it.

But the DRIP also offers a significant benefit: Whenever shares trade at a premium to NAV, distributions are reinvested at the NAV or at 95 percent of the market price. So at the very least, DRIP participants will never pay the market price when PDT trades at a premium. When it trades at a discount, reinvestments are done at the prevailing market price.

Khoa: I’m exhausted. Are we done yet?

Ari: Wait, there’s more! One important distinction that we haven’t yet mentioned: Unlike mutual funds, CEFs have a fixed number of shares, which enables them to avoid the deleterious effect on returns that mutual funds can suffer as the result of mass redemptions during downturns. And this stable asset base also affords the flexibility to invest in less liquid securities.

However, many CEFs periodically raise additional capital through secondary issuances or via rights offerings to existing shareholders.

Khoa: Has PDT done any secondary issuances recently?

Ari: No. In fact, according to the data I’ve reviewed, it doesn’t appear to have done any secondary issuances since its initial public offering (IPO) back in late 1989.

In 2007, however, PDT acquired nearly $525 million in additional assets via a reorganization during which four other John Hancock funds were folded into it, so additional shares were obviously created at that point to account for all the new assets. This caused the number of assets under management to jump nearly fourfold, from $193.4 million as of Oct. 31, 2006, to $709.2 million a year later.

PDT also issues a small quantity of shares through its DRIP. For instance, in its fiscal year ended Oct. 31, 2012, it issued slightly more than 38,500 shares, which brought its total share count to just over 50 million.

Khoa: I’m sorry I asked. What about the annual expense ratio?

Ari: CEFs are required to report the interest expense they pay for leverage as part of the expense ratio, and that can make the overall expense ratio seem high. Including interest expense, the gross expense ratio was recently 1.74 percent, but net of that expense, it’s actually 1.38 percent. According to Lipper, that puts it about 15 basis points above its peer group’s median expense ratio.

While I’d prefer management to charge a cheaper rate, it has been declining over time. And of course, they’ve delivered excellent returns while maintaining a high payout. I believe they’re worth it.

Buy John Hancock Premium Dividend Fund below 13.75. CEFs often have relatively low trading volumes. PDT’s average trading volume over the past three months was around 170,000 shares per day. As such, be sure to use a buy limit near the market price to avoid overpaying for shares.