John Hancock's preferred pick for income

Focused on utility and financial preferreds, this closed-end fund seeks high income.

By TheStockAdvisors Aug 9, 2013 12:29PM
copyright Digital VisionBy Ari Charney, Big Yield Hunting

John Hancock Premium Dividend Fund (PDT) is basically an actively managed mutual fund, but it just happens to trade on an exchange. Income-oriented investors will appreciate this closed-end fund's mandate, which requires it to deliver high current income along with modest capital gains.

The fund tends to allocate roughly 30% to 40% of the portfolio to equities and 60% to 70% 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 does so while delivering excellent long-term returns.

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

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% over the past five years.

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% annually on a net asset value (NAV) basis, 0.9% annually on a price basis, and 7.2% 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.

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.

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.

The financial sector's dominance of preferred stock issuance could soon change, as the Federal Reserve has 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. It remains to be seen how these changes will affect the preferred market.

Finally, investors should be aware of the fund's dividend reinvestment program (DRIP). New investors are automatically enrolled, 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% 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.

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