PFO: Very Attractive Price, But I Am Not Impressed (NYSE:PFO)

The Flaherty & Crumrine Preferred Income Opportunity Fund (NYSE:PFO) is a high-yielding closed-end fund (“CEF”) that investors can use for the purpose of income generation. As I have discussed in various previous articles, this is something that has taken on a new level of importance over the past two years as inflation has begun to strain household budgets and force people to employ desperate measures simply to maintain their standard of living. However, this fund might not look very appealing right now, as its share price has declined by 20.17% over the past twelve months:

This is much more than the decline of many other income-focused assets. For example, the Bloomberg U.S. Aggregate Bond Index (AGG) is down 4.50% and the ICE Exchange-Listed Preferred & Hybrid Securities Index (PFF) is down 8.72% over the period. The latter of these is a pretty good benchmark comparison to this fund, as we will see later in this article. Unfortunately, it does seem likely that the price performance of the Flaherty & Crumrine Preferred Income Opportunity Fund will continue to disappoint, as Chairman Powell recently stated that the Federal Reserve could hike interest rates further than it has done already. This expectation of “higher for longer” is the reason why most income-focused assets declined since the start of August, as the market was previously expecting a near-term rate cut.

The fact that the fund’s price has declined so far over the past year could be creating an opportunity for investors though. Right now, the shares are trading at an enormous discount to their intrinsic value and the fund is yielding 7.02%, which makes it one of the few things out there right now that has a positive real yield. As this situation is somewhat intriguing, let us investigate and see if this fund could be a good addition to your portfolio today.

About The Fund

According to the fund’s webpage, the Flaherty & Crumrine Preferred and Income Opportunity Fund has the objective of providing its investors with a high level of current income while still preserving the value of its principal. The name of this fund implies that it is a fixed-income fund, and this is a very common objective for such a fund. The fund’s description of its strategy appears to confirm this, as its website states:

“Under normal market conditions, the fund invests at least 80% of its managed assets in a portfolio of preferred and other income-producing securities. Preferred and other income-producing securities may include, among other things, traditional preferred stock, trust preferred securities, hybrid securities that have characteristics of both equity and debt securities, contingent capital securities, subordinated debt, and senior debt.”

The fund’s portfolio largely fits with this objective as it is primarily invested in preferred stock and bonds, although it also has some limited exposure to convertible securities and cash:

I will admit that this is a lower allocation to preferred stock than I expected to see considering the fund’s name and its description of its strategy. However, preferred stock and bonds have many of the same characteristics, so it is not really a problem. In fact, preferred stock acts largely like a bond that has no maturity date. The only real difference is that a company can technically skip a preferred stock payment without going into default, as would be the case if it skipped a bond payment. As such, preferred stock usually has a higher yield than bonds issued by the same company. This is intended to compensate preferred stockholders for the extra risks that they are taking.

The fund’s desire for capital preservation works well with a portfolio of both preferred stocks and bonds, as both of these securities tend to be much less volatile than common stocks. In fact, a bond investor that holds a bond over its entire life will not lose money in nominal terms unless the issuing entity defaults. After all, a bond is purchased at face value when it is first issued, makes a regular payment to the investor, and then is redeemed by the issuing entity at face value when it matures. The same thing is generally true of preferred stock, although as mentioned, there is no maturity date. There are instances when a preferred stock can be called back or redeemed by the issuing entity though, which is usually done at par value (analogous to the face value of a bond). As such, investors who are interested in capital preservation may gravitate to bonds and bond funds.

Of course, bond funds rarely hold their securities to maturity, and in fact, the Flaherty & Crumrine Preferred and Income Opportunity Fund has an 8.00% annual turnover. That is incredibly low for a fixed-income fund though, which implies that this one is not engaging in a substantial amount of trading and probably does hold some bonds to maturity.

With that said, the fund’s price can be expected to change over time due to the fluctuating price of the bonds in the portfolio. This is due to interest rates, which have been rising over the past year and a half. As we can see here, the effective federal funds rate currently sits at 5.12%, which is the highest level that it has had since 2007:

This has pushed down the price of any bond with a fixed coupon rate. The same is true of preferred stock with a fixed dividend. Floating-rate securities will hold their value much better in such an environment, but this fund is not really investing in those. Indeed, the fund’s semi-annual report makes no mention of floating-rate securities, although some of the preferred stocks in its portfolio do convert to a floating rate over the next few years. The fund’s share price is generally going to vary based on the current market price of the bonds in its portfolio, regardless of whether or not the fund actually holds these securities to maturity.

The fact that this fund is more heavily weighted towards preferred stock than bonds amplifies its interest rate movements. As mentioned in the introduction, the ICE Exchange-Traded Preferred & Hybrid Securities Index declined more than the Bloomberg U.S. Aggregate Bond Index over the past year. This is due to the lack of a maturity date on preferred stock. As a result, the duration of preferred stock tends to be higher than the duration of most bonds. Duration is a measure of interest rate sensitivity, so preferred stock will ordinarily decline more than bonds when interest rates rise. Thus, the fact that the Flaherty & Crumrine Preferred and Income Opportunity Fund is weighted towards preferred stock means that it will normally decline more than an all-bond portfolio. We see that in the fund’s performance over the past year.

As we saw in the introduction, the Flaherty & Crumrine Preferred and Income Opportunity Fund declined by a lot more than both the bond and the preferred stock indices over the past year. The difference between the bond and the preferred stock indices was 422 basis points, which is quite a lot. However, this fund is down by 1,145 basis points more than the preferred stock index. This history of underperformance extends over much more than a year. This chart compares the fund against both indices on a total return basis over the past five years:

It is much better to use total return as a comparison than price return as that takes into account the fact that the three assets have different yields. In some cases, the yield can be enough to offset differences in price performance. As we can see here, though, the only one of these three assets that lost money over the past five years was the Flaherty & Crumrine Fund. An investor in either of the indices would have at least made something (albeit not very much in the case of the bond index). It is a different story when we extend the period out to ten years, however. In this case, the Flaherty & Crumrine Preferred & Income Opportunity Fund outperformed both indices by a comfortable margin:

It is important to note though that total return means that distributions are being reinvested. Most income-focused investors are not doing that as they want the income to be spent on bills or other lifestyle expenses. However, the asset with the highest total return will still result in the most money left over at the end of a given period even in that instance. As we can see here, the closed-end fund underperforms except over very long time periods.

Leverage

One advantage that closed-end funds have over exchange-traded or open-ended funds is the ability to employ certain strategies that boost its effective portfolio yield. I explained how this strategy works in a previous article:

“In short, the fund is borrowing money and using that borrowed money to purchase preferred stock, bonds, and other income-producing securities. As long as the yield of the purchased assets is higher 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 considerably lower than retail rates, this will usually be the case. However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses.”

The fund’s use of leverage could be one of the reasons for its underperformance during certain time periods. One thing that we note by looking at the chart above is that the movements of the Flaherty & Crumrine Preferred and Income Opportunity Fund tend to be pretty similar to those of the indices in terms of direction. However, the Flaherty & Crumrine fund tends to move much more in both directions. Thus, it declined much more than the indices did in response to the rising interest rate environment, and that was a big reason why it underperformed over the past five years. This larger decline may have been caused by the fund’s use of leverage.

This fund’s leveraged assets comprise 41.13% of its total portfolio as of the time of writing, which is far above the one-third maximum that I usually like to see. This leverage ratio is also somewhat higher than most other fixed-income closed-end funds usually employ. Thus, the risks here are going to be somewhat higher than with similar funds that employ lower levels of leverage. That is something that a conservative investor may be concerned about.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the Flaherty & Crumrine Preferred and Income Opportunity Fund is to provide its investors with a high level of income. In order to achieve that objective, the fund invests its assets in preferred stocks and bonds that will deliver most of their investment returns through direct payments to their owners. They also tend to have fairly high yields in today’s environment, at least when compared to what most of us have experienced over the past decade. The fund then applies a layer of leverage to artificially boost its effective yield well beyond that of the assets in the portfolio.

As such, we might expect that this fund will boast a very high yield itself. That is certainly the case as the fund pays a monthly distribution of $0.0450 per share ($0.54 per share annually), which gives the fund a 7.02% yield at the current price. Unfortunately, this fund has not been particularly consistent with its distribution over the years. It increased and cut the distribution multiple times over its existence, including four distribution cuts in the past year:

This history is almost certainly going to be a turn-off for anyone who is seeking a safe and secure source of income to use to pay their bills. The fact that the fund has cut its distribution four times in the past twelve months is certainly going to be concerning. With that said, most fixed-income funds were forced to cut their distributions over the past year due to capital gains being very hard to come by in the fixed-income sector. Indeed, almost any fund that had to sell bonds during the past year realized some losses. This is one of the reasons for the troubles that the banking sector experienced earlier this year, too.

As I have pointed out numerous times in the past, though, anyone buying the fund today will receive the current distribution at the current yield. They will be unaffected by any actions that the fund took in the past. As such, the most important thing is determining how well the fund can sustain its current distribution. Let us investigate this.

Fortunately, we have a very recent document that we can consult for the purposes of our analysis. The fund’s most recent financial report corresponds to the six-month period that ended on May 31, 2023. This is one of the newest reports that has been released across the fund’s peer group, and it should give us a good idea of how well the fund performed in the first half of this year. The bond market was actually pretty strong over most of this year due to the market (wrongly) expecting that the Federal Reserve will cut rates in the near future. This strong market could have allowed the fund to realize some capital gains.

During the six-month period, the Flaherty & Crumrine Preferred and Income Opportunity Fund received $2,498,502 in dividends and $4,287,948 in interest from the assets in its portfolio. When we combine this with a small amount of income received from other sources, the fund had a total investment income of $6,805,841 over the period. It paid its expenses out of this amount, which left it with $3,695,058 available for shareholders. As might be expected, this was not enough to cover the $4,027,816 that it paid out in distributions over the six-month period. The fund did get pretty close, but the fact that it did not cover its distributions with net investment income still might be concerning to some investors.

However, the fund does have other methods through which it can obtain the money that it needs to cover the distributions. For example, the fund might have capital gains that could be paid out. Unfortunately, it failed miserably in this respect. The fund reported net realized losses of $3,063,665 and had another $6,304,129 net unrealized losses.

Overall, the fund’s assets declined by $9,700,552 after accounting for all inflows and outflows during the period. That certainly explains the distribution cuts over the past year as the fund was failing to cover its distribution. It remains to be seen if it can maintain the current payout, however, the fact that its net investment income is pretty close to the amount actually being paid out gives us confidence that it will probably be okay in the absence of any more large losses.

Valuation

As of August 28, 2023 (the most recent date for which data is currently available), the Flaherty & Crumrine Preferred and Income Opportunity Fund has a net asset value of $8.82 per share. However, the shares currently trade for $7.67 each. That gives the fund’s shares a 13.04% discount on net asset value. This is quite a bit better than the 11.41% discount that the shares have had on average over the past month, so the price certainly looks acceptable here.

Conclusion

In conclusion, investors continue to seek income today in an attempt to maintain their lifestyles in the face of the highest inflation that we have seen in forty years. The Flaherty & Crumrine Preferred and Income Opportunity Fund offers a way to accomplish that goal, although its 7.02% yield is lower than many peers. The fund also has a history of underperforming the broader market indices, which may be due to its incredibly high level of leverage. While the price is certainly very reasonable here, I must admit that I am rather unimpressed with the Flaherty & Crumrine Preferred Income Opportunity Fund.