Virtus InfraCap US Preferred Stock ETF: Buy The Dip (NYSEARCA:PFFA)

Introduction

I’ve previously published articles here on Seeking Alpha, covering the Virtus InfraCap US Preferred Stock ETF (NYSEARCA:PFFA). Since the last article was published in January 2024, PFFA was up smartly riding the expectation that the Federal Reserve would begin an aggressive interest rate reduction campaign as early as March. Over the last couple of weeks, along with most fixed income assets, the price of PFFA has dropped by 4.9% as investors have come to understand what “higher for longer” really means. The economy has shown to be stronger than expected and inflation a bit stickier than expected, prompting the Federal Reserve to push out any reduction in the Federal Funds Rate to September or later.

So, the bad news for fixed income investors is that we will have to wait at least a few more months before seeing our carefully selected fixed income assets appreciate in value as the Federal Reserve begins to lower interest rates. The good news is twofold. Fixed income investors get another opportunity to invest in PFFA at a lower price, and we get to enjoy collecting a roughly 10% dividend while waiting on the Federal Reserve.

Why Buy PFFA On This Dip?

It is pretty clear to me that the stock market, and to a lesser extent the bond market, got a little overly euphoric over the prospect of an aggressive interest rate reduction cycle beginning this past March. With the US economy showing continued growth as the Federal Funds Rate sits at 5.33% and with the inflation rate proving to be sticky, the Federal Reserve has not much reason to reduce the Federal Funds Rate. Powell said in his speech today that the current level of restrictive monetary policy needs more time to work; effectively another way of saying “higher for longer”.

The fixed income market took the news pretty hard and sold off accordingly. However, I view this as a temporary correction and, therefore, an opportunity to put additional funds to work in fixed income assets. The US economy is showing some signs of slowing. Home sales and single family residence construction have begun to slow down. The unemployment rate bottomed about a year ago at 3.4% and has very slowly risen to 3.9% with more recent layoffs being announced. Finally, used car prices are falling, and dealer inventory is growing. All of these are indicators of a slowing economy, albeit, an economy slowing slowly. I’m fairly confident that the Federal Reserve will be in a position to begin lowering interest rates late this year or early next year. When the Federal Reserve does begin lowering rates, fixed income investment valuations will rise.

I think the chart below shows a very interesting short-term trend.

Over the past year, on a total return basis, PFFA kept up with the S&P 500 index up until the beginning of February 2024 when PFFA valuation took a harder downturn. This appears to be due to the recognition that interest rates will be “higher for longer” and a March or even June interest rate cut was not in the cards. Since nothing changed in PFFA’s portfolio, management approach, or investment policy, that steep downturn has to be due to the expectation for higher interest rates at least past June. Using an analogy from Newton’s Third Law of Physics, “for every action, there is an equal and opposite reaction”. PFFA valuation fell appreciably as interest rates rose, so PFFA valuation will rise appreciably as interest rates fall.

Before anybody takes umbrage with the comparison chart above, I’m not suggesting that PFFA will provide similar returns as the S&P 500 index over the long term. In this case, the past is a fairly good predictor of the future and over the long term, PFFA has not kept up with the S&P 500.

In addition to the tailwind that falling interest rates will provide to PFFA and other fixed income assets, PFFA investors will benefit from the Fixed-to-Floating (FTF) and Reset rate securities held in the portfolio. Readers should note that the charts below do not represent the entirety of PFFA’s portfolio holdings, but only those securities that are either FtF or Reset Rate securities, about 37% of PFFA’s portfolio by asset value. For those interested, a complete listing of PFFA’s portfolio holdings can be downloaded from the Virtus website.

The first chart below shows those FtF and Reset Rate securities that have already transitioned to their respective floating rate or reset rate.

The column headings are straightforward, with the possible exception of the last two. The column titled “FtF or Reset Spread” is the floating rate or reset rate interest spread between the appropriate index and the floating or reset rate for the security. The “FtF or Reset Index” lists the base index rate for each security. For example, US0003M is a synthetic 3 month LIBOR based on the CME 3 month SOFR. The “Coupon” column provides the current floating rate or reset rate for each security.

The following charts provide the PFFA portfolio securities that will convert to their respective floating rate or reset rate over the next roughly 3 years.

As these FtF and Reset Rate securities convert to their respective floating rate or reset rate, PFFA’s dividend income stream will increase. If we had an accurate crystal ball, and knew which of these securities would be called rather than converting to a higher floating or reset rate, we could calculate the increase in dividend income as a function of time. Unfortunately, my crystal ball is not that accurate. However, it is still pretty much a win for PFFA investors regardless of whether the security is called or not, since most of the securities were purchased below par value. So, we are either going to get an increased dividend stream if the securities are not called or an increase in both PFFA NAV and price if the securities are called. I expect we will get some of both. PFFA management raised the monthly dividend in January 2024, and I expect we will get another increase in January 2025.

Answering the Usual Questions

When I or other SA authors publish an article, we frequently get a typical set of questions in the comments section. Hopefully, I can answer some of those questions ahead of time.

1. Why is the PFFA expense ratio higher than most other ETFs?

There are two reasons why the expense ratio is higher than many ETFs. First, PFFA is not an index fund, it is actively managed. Index funds typically require little active management because the portfolio is designed to mimic an already existing index. If a new security is added to or dropped from that existing index, it is added to or dropped from the fund. In actively managed funds, the Portfolio Manager or Chief Investment Officer (CIO) makes the individual decisions on which securities are added to or sold out of the fund portfolio. Actively managed funds, depending on their size, typically have analysts on staff to provide the CIO with the data necessary to make those decisions. The PFFA management fee is 0.80%.

Second, PFFA is a leveraged ETF. PFFA management uses credit to leverage the fund’s holdings and boost investor returns. Currently, PFFA is roughly 24% leveraged. Using leverage is very common among Closed End Funds (CEFs) but fairly uncommon among ETFs. The other aspects of a leveraged fund that investors should understand is that leverage tends to accentuate the fund’s price volatility. When interest rates are rising, leveraged funds prices typically drop faster than non-leveraged funds. When interest rates fall, leveraged funds prices typically rise faster than non-leveraged funds. The cost of credit is significantly higher now than it was 2-3 years ago and PFFA’s expenses have risen as a result. Currently, the cost of credit and other expenses is 1.72%. This makes up the total expense fee of 2.52%.

2. Doesn’t the higher management and expense fee reduce investor’s returns?

While it is true, for example, that if the cost of credit (leverage) was lower, the money saved from cheaper credit could be distributed to investors. It is also true that doing away with leverage would lower the overall return to investors. So, the cost of leverage is a cost that benefits investors by providing higher overall returns. It should also be noted the dividend yield published for PFFA is net of all expenses as required by the SEC for all US exchange traded securities. The current PFFA annual dividend is $2.01 paid as $0.1675 monthly. The closing price of PFFA on Tuesday, April 16 was $20.10 per share, so the investor’s dividend yield is exactly 10%.

3. If interest rates drop, won’t the floating rates also drop, thus lowering the funds yield and price?

I’ll answer this by using an example. Take RITM.PR.A as an example. The original fixed period coupon is 7.5% ($1.875 annual). The floating rate, starting 8/15/2024, will be 3 mo LIBOR (3 mo SOFR + 0.261%) + 5.80%. With 3 mo SOFR today at 5.33%, the floating rate would be 11.39%. The Federal Funds Rate and SOFR travel pretty much hand-in-hand. To push the floating rate back down to the level of the original fixed coupon rate would require the Federal Reserve to lower the current Federal Funds Rate from 5.25-5.5% range by roughly 390 basis points (3.9%). The Federal Reserve typically moves up and down its rate cycle in 25 basis point increments, occasionally in 50-75 basis point increments. It will take the Federal Reserve several months to drop the Federal Funds Rate by 390 basis points, even on a highly aggressive schedule. A much more likely course for falling rates will be 25 basis point increments spanning 2-3 years.

What Are The Risks?

As we have seen recently, there is some interest rate risk still with us in response to sticky inflation readings. PFFA dropped by almost 5% in the span of 3 weeks. My personal view on this is that the drop was an over-the-top response to the recent sticky inflation readings and investor’s recognition that rates are really going to be higher for longer. I do not expect to see a long term continued uptrend in interest rates. Therefore, I’m treating this pull back in fixed income prices as a buying opportunity versus a risk.

Bank and REIT preferred shares make up a significant portion of the PFFA portfolio. Neither do well during periods of recession. If we do get a hard landing with the economy entering a recession, PFFA pricing could suffer as will most equities and, to a lesser extent, other fixed income securities.

Overall, I consider the risks to be limited, particularly in comparison to the potential return.

Conclusion

The recent sticky inflation reports have pushed interest rates up and equities down. I believe this is a temporary blip in the long-term downtrend for inflation. Housing, autos, and employment are trending slowly downward. Ultimately, the Federal Reserve will get the necessary data points to confirm that inflation will get back to ~2% and interest rates will begin to fall. Fixed income securities, and particularly PFFA, will benefit from falling rates directly as well as benefiting from the growing dividend stream from FtF and reset rate securities converting to higher coupon rates. The recent price dip is an opportunity from which investors can benefit.