Description

Hi, guys --

No, no -- please! Please, everyone! Stop! Please, people, sit down! There is no need to be so effusive in your applause for this low-conviction trade idea that I own in modest size in my personal account!

JPI is an unseasoned, Nuveen-sponsored closed end fund that owns preferreds from banks and insurance companies. It's trading at an ~11% discount to net asset value and a ~9% yield. Here's a quick snapshot:

Price: $21.96

NAV: $24.56

Discount: -10.59%

Yield: 9.23%

Assets: $786MM

Leverage: $225MM

Leverage %: 28.6%

Fees (as % of assets): %0.91

Top 10 Issuers: A bunch of too-big-to-fail American and European banks & insurance companies.

The Pitch

Let's get the asset class out of the way first. Preferred stocks are the scratch-off lottery tickets of the investment world, for suckers and degenerates only, in God's name who buys this stuff? Would you marry someone if you only got it when she was in the mood, and after five years she could back out at any time, but otherwise you were stuck for life? And don't even get me started on non-cumulative preferreds -- what, do I look like I'm 8 years old? So I give you Boardwalk and you give me Baltic Avenue and that's supposed to be fair because they're pretty much the same color? Well f*ck you, Jack.

OK, I don't like preferreds. What, then, is the appeal of JPI? Well, it's a 9% coupon with minimal rate risk, thanks to swaps, floaters and fixed-to-float issues.

Let be me frank: This trade recommendation is not based on detailed modeling of every element of the portfolio, although I've looked at some of the larger positions just to make sure they exist, and that the call/conversion date on some of the FRAPs is near enough to make a difference. I am relying on the self-reported NAV provided by JPI's management. For all I know, this number comes from an intern casting yarrow sticks and then plugging the results into Excel 5.0. I have background in Fudged In -- err, I mean, Fixed Income -- and I've worked at places where that was essentially the methodology. I hope that's not the case here. Nuveen is a reputable house, I assume  they have access to market data and a vetted and standardized suite of analytics that's capable of pricing the stuff that doesn't trade, including rates, spreads, calls, etc

Now let's get down the serious number-crunching, and by "serious number-crunching," I mean, "eyeballing charts from Yahoo! Finance," although I'll use some FRED graphs too, just to try seem more professional. (Grumble -- so much for the veneer of professionalism, now I'm just another idiot who can't figure out how to get charts to work on VIC -- it can be, done, see the latest MOS write-up)

Here's 10 year Treasuries rates (I think we all know that story) and BB spreads, which I'm using as a proxy for preferred spread, for the last year:

 [Omitted]

Let's zoom in to the taper tantrum:

 [Omitted]

From May 1 to September 5, rates go from 1.6% to 3%; spreads bounce around a bit, but don't really change (for what it's worth, Merrill has preferred spreads generally widening over the period).

Courtesy of cefconnect.com, here's JPI's price and NAV for the last year:

 http://www.cefconnect.com/Details/Summary.aspx?Ticker=jpi

Here's the money chart, from Yahoo! Finance, where we compare JPI's price and NAV to some hopefully relevant alternatives:

http://finance.yahoo.com/q/bc?t=1y&s=JPI&l=on&z=l&q=l&c=xjpix%2Ctlt%2Cief%2Cpff&ql=1 

Blue = JPI, Green = JPI NAV, Red = TLT (an ETF basically representing the long bond), IEF (7-10 year treasury ETF), and PFF (broad-based preferred ETF).  It certainly appears to the eye that,  post taper-talk, JPI is trading in line with 30-year treasuries, while it's NAV has pretty much gone it's own way. Nuveen reports leveraged duration of 8, but, empiricallly, when rates were rising this was more like 3-4.

You'll note that I'm not trying to fool anyone with false precision. JPI's a black box, holdings can change at any time, the time series is short, etc. etc -- but it does not look, right now anyway, that another 50-100 bps is going to crush NAV.

What's going on here is that they've got $168MM in swaps, a lot of high coupon stuff and the market is pricing the fixed-to-float issues to call, so the duration is _much_ shorter than one would think from the theoretically unlimited life of straight preferred stocks.

The Trade

I'm hoping for a January/February bounce, as often happens with CEFs: pick up a couple of distributions and say 5% of discount narrowing for a nice annualized return. If that doesn't happen, I could see total returns over a year looking something like:

+9% Yield

-3% Rates

+4% Spread

+5% Discount =

15%,

call it low-mid teens, which also has a certain naive appeal. And if JPI would just promise to not blow up, I'd gladly hold it for the rest of my life.

Risks

The main risks are:

-- Credit exposure to financials, split 60:40 between the US and Europe.

-- Rates go through the roof.

-- Retail holders could dump even more causing the discount to widen further.

-- Black box/lackadaisical due diligence. What's the weighted average maturity date? Average spread if the FRAPS don't get called? Worst-case Basel III impact? I don't know, I don't know, and I don't know.

Other Stuff

Fees aren't outrageous, and maybe even worth it for the individual investor. Let's say, "Here, you keep an eye on this stuff," is worth 50 bps on its own. JPI can also access 144a preferreds (currently 75% of the portfolio). I could see relative value trading between retail/institutional preferreds being worth 50 bps. Shucks, annual rebalancing on a 60/40 S&P 500/bond mix is worth 50 bps.

Management commentary seems rational. They're aware of and trying to outperform their benchmarks without getting all crazy about it.

Is this the best/cheapest preferred CEF out there? I don't know, please suggest alternatives. Is long JPI the optimal way to get credit exposure to financials? I'm sure not, please suggest alternatives. Could the portfolio be replicated via IR futures, index options, single-name CDS, and dividend swaps, without the need to pay onerous discount brokerage fees? Doubtless it could, I eagerly await your VIC writeup.

Another way of looking at this is: There's some leverage involved but preferreds are in theory higher up the capital structure, so let's squint real hard and round things off and say that we're buying some largish financials at an 11 PE, with the "E" delivered in cash. Not so bad.

What's right here is discount, coupon, relative NAV trend; what's wrong is rate macro, tail risk, and that the NAV trend is really short-lived.

Latest commentary:

http://www.nuveen.com/Home/Documents/Default.aspx?fileId=58295

Fund website:

http://www.nuveen.com/CEF/Product/Holdings.aspx?fundcode=JPI

Yours,

Bowd

Catalyst