HPS: Good Earnings Fund, However Premium Valuation A Flip-Off

In numerous earlier articles, reminiscent of this one, I mentioned how the excessive inflation at the moment dominating the USA economic system has precipitated quite a few folks to make efforts to extend their revenue. The John Hancock Most well-liked Earnings Fund III (NYSE:HPS) is one technique via which this purpose could be completed. This can be a closed-end fund that focuses on offering a excessive degree of present revenue to its shareholders, which is instantly evident in its 9.60% yield. That is clearly a a lot greater yield than most different issues available in the market, significantly the S&P 500 Index (SPY) and even the ICE Change-Listed Most well-liked & Hybrid Securities Index (PFF), which is certain to be engaging to any income-focused investor. Sadly, the fund has not been performing very effectively currently available in the market as its shares are down 15.14% over the previous twelve months:

This poor efficiency might very simply be defined by the truth that rates of interest have risen considerably over the interval and thus pushed down the value of absolutely anything that’s centered on revenue. We’ll talk about that extra within the article, in addition to present that the fund’s efficiency has general not been as unhealthy as this chart would lead one to consider.

As some readers might recall, I final discussed this fund in October of 2021. My thesis on the time was comparable, as the entire level of this fund was to offer its buyers with revenue. Nonetheless, none can argue that the market surroundings has modified considerably because the “simple cash” days of 2021 so this text will focus particularly on highlighting these modifications. It would additionally present an replace on the fund’s funds since clearly, these have modified over the previous two years. Allow us to examine and see if this fund might be a worthwhile funding right now.

About The Fund

In line with the fund’s webpage, the John Hancock Most well-liked Earnings Fund III has the target of offering its buyers with a excessive degree of present revenue whereas nonetheless making certain the preservation of principal. That goal makes quite a lot of sense contemplating the fund’s technique. As we will see right here, the fund particularly states that it seeks to realize its goal by investing in a portfolio of most well-liked inventory and convertible most well-liked securities:

The fund’s portfolio as an entire appears to adjust to the technique described on the webpage. As we will see right here, 77.36% of the fund’s belongings are invested in most well-liked inventory with the rest invested in bonds and convertible securities. Surprisingly although, the fund does have a 7.05% allocation to frequent inventory:

For essentially the most half, most well-liked inventory and bonds are usually much less risky than frequent inventory. That is the rationale why many fixed-income funds state that they’re trying to protect principal as a part of their funding targets. Actually, it’s unimaginable to lose cash by investing in bonds in case you maintain the safety to maturity, except the issuer defaults. It is because a bond is bought at face worth when it’s first issued and redeemed for its face worth upon maturity. Most well-liked inventory is kind of comparable, besides that it doesn’t have a maturity date. Nonetheless, since neither safety has any inherent hyperlink to the expansion and prosperity of the issuing entity, it sometimes stays comparatively steady over time, a minimum of in comparison with frequent inventory. That is fairly apparent if we take a look at the value return for the S&P 500 Index, the Bloomberg US Mixture Bond Index (AGG), and the ICE Change-Listed Most well-liked & Hybrid Securities Index over the previous ten years. Right here is the chart:

As we will see, each of the fixed-income indices had been way more steady than the S&P 500 Index over the ten-year interval. Thus, investing in these securities tends to be a greater option to protect principal than taking over the added danger of shares. Shares do have a a lot greater potential for returns due to their greater danger although, so the truth that the John Hancock Fund consists of some publicity to those securities permits it to learn from that.

In my earlier article on the John Hancock Most well-liked Earnings Fund III, I identified that the fund is closely invested within the banking sector. That continues to be the case, though it does have some publicity to different sectors. We will see this by wanting on the fund’s largest positions. Right here they’re:

As we will see, lots of the firms on this record are banks or different monetary establishments, though we do have three utilities and a midstream partnership. The prevalence of banks among the many fund’s holdings could also be regarding to some risk-averse buyers, in any case, there have been numerous massive financial institution failures earlier this yr. Nonetheless, it’s a frequent scenario for a most well-liked inventory fund. I defined why in my earlier article on this fund:

The very first thing that we discover right here is that each one of those firms are both utilities or banks. This isn’t unusual for a most well-liked inventory fund as a result of banks and utilities are the most important issuers of most well-liked inventory available in the market. Because of this, virtually any most well-liked inventory fund might be very closely weighted in direction of these two kinds of entity. With that stated although, often the overwhelming variety of firms within the high ten record are banks. This is because of worldwide banking laws that require banks to carry a sure share of their belongings within the type of Tier One capital. Tier One capital refers to that proportion of a financial institution’s belongings that aren’t concurrently a legal responsibility to any person else (reminiscent of a depositor). When regulators require that the financial institution enhance its Tier One capital, its solely choices are to problem both frequent or most well-liked inventory. The financial institution will typically select to problem the popular inventory so as to keep away from diluting the frequent stockholders. A utility doesn’t have these laws to comply with however they turn into heavy issuers of most well-liked inventory as a consequence of the price of their infrastructure. This can be very costly to construct a community of utility-scale infrastructure over a large geographic space. The utility firm will typically finance the development of this infrastructure with debt, however the firm will often need to keep away from taking over an excessive amount of debt and changing into overleveraged. Thus, it’s going to typically problem most well-liked inventory to partially cowl the bills in order that it may keep away from an excessive amount of debt or frequent inventory dilution.”

There have been numerous modifications to the highest ten record since we final mentioned this fund. These embrace all the following:

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Please observe that a few of these positions are most well-liked inventory, not frequent inventory. Nonetheless, the fund’s month-to-month portfolio record is unusual. It particularly states that a few of these positions are both company bonds or most well-liked inventory. Nonetheless, it doesn’t state what particular problem they’re, and the ticker image offered by the fund sponsor is particularly for the frequent inventory. As such, we can not say something greater than the truth that they’re some kind of safety issued by the respective firm. The month-to-month positions record could be downloaded from the fund’s web site if you wish to peruse it your self.

The truth that a pretty big variety of securities within the largest positions record had been modified because the final time that we mentioned this fund doesn’t essentially imply that its annual turnover is excessive. In any case, it has been virtually two years since that earlier article was revealed. Actually, the John Hancock Most well-liked Earnings Fund III solely had a 20.00% annual turnover as of July 31, 2023, so it isn’t significantly lively in buying and selling securities. That is good as a consequence of the truth that it helps to maintain the fund’s buying and selling bills down.

The John Hancock Most well-liked Earnings Fund III has carried out exceptionally effectively towards index funds over the previous ten years. As we will see right here, the fund delivered an 82.50% whole return over the trailing decade, which is considerably above each the Bloomberg U.S. Mixture Bond Index and the ICE Change-Listed Most well-liked & Hybrid Securities Index:

That is one thing that can undoubtedly attraction to any investor. Nonetheless, you will need to take into account that the above chart assumes that each one distributions acquired by the funds are reinvested. Lots of people who put money into income-focused funds will not be reinvesting the whole distribution that they obtain, so their returns could be decrease as a result of decrease compounding. Nonetheless, the John Hancock Fund nonetheless would have served you higher in the long term. It’s also vital to take into account that previous efficiency is not any assure of future outcomes. Specifically, we will see that this fund tends to drop way more than both of the indices in each late 2018 and 2022, which had been intervals wherein the Federal Reserve was elevating rates of interest to sluggish the economic system. That can doubtless proceed to be the case going ahead as a consequence of this fund’s use of leverage. Analysts are at the moment anticipating that Chairman Powell will counsel that charges will keep greater for longer at his Jackson Gap speech later this week. If that occurs, this fund might decline greater than both of the indices.

With that stated, any decline as a consequence of rates of interest will doubtless be a short-term phenomenon. It’s troublesome to consider that the Federal Reserve will have the ability to hold charges at right now’s ranges for an prolonged time frame due merely to the Federal Authorities’s budgetary issues. To place it merely, the USA Authorities can not afford 4%+ rates of interest on Treasuries indefinitely. This fund’s leverage will work in its favor when rates of interest do begin to decline as a consequence of its impact of boosting features.

Distribution Evaluation

As talked about earlier on this article, the first goal of the John Hancock Most well-liked Earnings Fund III is to offer its buyers with a excessive degree of present revenue. With the intention to obtain that goal, it invests in a portfolio of most well-liked shares that ship most of their funding returns by way of direct funds to their house owners. These securities are likely to have a reasonably excessive dividend yield in consequence. The fund then applies a layer of leverage to spice up the efficient return of its portfolio. It then pays out most of its funding earnings to its personal shareholders. As such, we will assume that the fund has a really excessive yield itself. That’s definitely the case because the fund pays a month-to-month distribution of $0.11 per share ($1.32 per share yearly), which supplies it a 9.60% yield on the present value. The fund has typically been very in keeping with its distribution over time, though it has diversified every so often:

That is really way more steady than many different fixed-income funds have been not too long ago. Certainly, we will see that the John Hancock Most well-liked Earnings Fund III didn’t alter its distribution in any respect in response to the Federal Reserve’s change in financial coverage final yr. Actually, the final distribution change was all the way in which again in October 2019. This might endear the fund to these buyers who’re looking for a secure and safe supply of revenue to make use of to pay their payments or finance their life. As is all the time the case although, we need to make sure that it’s sustainable.

Thankfully, we do have a considerably current doc that we will seek the advice of for the needs of our evaluation. As of the time of writing, the fund’s most up-to-date financial report corresponds to the six-month interval that ended on January 31, 2023. It would thus not embrace details about the fund’s efficiency over the previous six months, however it’s going to nonetheless give us a good suggestion of how effectively the fund’s administration navigated the difficult situations that existed final yr. A administration crew’s means to deal with troublesome situations can generally be extra priceless than its means to carry out throughout simple situations.

Through the six-month interval, the John Hancock Most well-liked Earnings Fund III acquired $15,858,767 in dividends together with $9,437,925 in curiosity from the investments in its portfolio. After we internet out the cash that the fund needed to pay in international withholding taxes, we get a complete funding revenue of $25,243,352 for the interval. It paid its bills out of this quantity, which left it with $16,227,179 obtainable for the shareholders. That was sadly nowhere close to sufficient to cowl the $21,001,965 that the fund really paid out in distributions. That is regarding as we typically desire a fixed-income fund to cowl its distributions solely out of internet funding revenue.

With that stated, the fund does produce other strategies that may be employed to acquire the cash that it must cowl its distributions. For instance, it would have the ability to earn capital features that may be paid out. Thankfully, the fund did have some success at this, because it reported internet realized features of $4,493,299 in the course of the interval. Once we mix that with internet funding revenue, we get $20,720,478, which was sadly nonetheless not sufficient to cowl the distribution, however the fund did get fairly shut. Its internet unrealized losses in the course of the interval had been $17,858,666, which offset most of its features. General, the fund’s belongings declined by $17,417,269 after accounting for all inflows and outflows. Technically, the fund did not cowl its distribution.

At this level, some eagle-eyed readers may discover that the fund’s internet asset decline was really lower than its internet unrealized losses. That is even though internet funding revenue plus internet realized features was not ample to cowl the distributions. This may be defined by the truth that the fund’s shareholders reinvested $722,884 value of the distributions that had been paid out. This cash got here again into the fund and was used to assist the distribution. In impact, a number of the distributions had been paid in shares of the fund as a substitute of money. It’s most likely nothing to fret about because the fund did get very near overlaying its distributions, however it’s nonetheless one thing that we must always control.

Valuation

As of August 22, 2023 (the newest date for which knowledge is at the moment obtainable), the John Hancock Most well-liked Earnings Fund III has a internet asset worth of $13.18 per share however the shares at the moment commerce for $13.76 every. That offers the fund a 4.40% premium on internet asset worth on the present value. That’s higher than the 5.36% premium that the fund’s shares have averaged over the previous month, however it’s nonetheless a premium. As such, shopping for shares of this fund primarily means that you’re paying greater than the underlying belongings are literally value. I personally don’t like to purchase any fund at a premium for that purpose.

Conclusion

In conclusion, buyers right now are determined to keep up their revenue as a result of quickly rising costs all through the economic system. The John Hancock Most well-liked Earnings Fund III is an effective option to receive such much-needed revenue, and for essentially the most half, this can be a strong fund. The one actual adverse is that the fund is a bit costly proper now. It additionally did not cowl its distribution within the six-month interval that ended again on January 31, 2023, however not by very a lot. The fund is certainly value contemplating if it may be obtained at a reduction to internet asset worth, however the premium valuation is an enormous turn-off.