First Trust Intermediate Duration Preferred & Income Fund Update

Transcription

1 3rd Quarter 2014 Fund Positioning and Performance The First Trust Intermediate Duration Preferred & Income Fund produced a total return based on net asset value (NAV) for the third quarter of 2014 of 0.19% versus a total return of the blended index, a 50/50 blend of the BofA Merrill Lynch Fixed Rate Preferred Securities Index (P0P1) and the BofA Merrill Lynch US Capital Securities Index (C0CS) of 0.30%. The key drivers of the underperformance during the third quarter were an overweight in both fixed-tofloaters and institutional securities. 1, 2 Although both of these sectors within the preferred and hybrid securities market underperformed during the quarter, Stonebridge Advisors LLC, the fund s sub-advisor, continues to believe in their longer-term relative value. Figure 1. Performance (%) as of 9/30/14 Since Quarter YTD 1 Year Inception Fund Performance NAV Share Price Index Performance Blended Index Discount to NAV Distribution Rate 3 NAV Share Price FPF % 8.43% $24.36 $21.72 Performance data quoted represents past performance. Past performance is not a guarantee of future results and current performance may be higher or lower than performance quoted. Investment returns and principal value will fluctuate and shares, when sold or redeemed, may be worth more or less than their original cost. You can obtain performance information which is current through the most recent month-end by visiting ftportfolios.com. FPF continued its strategy of maintaining income while aiming to position the portfolio to outperform the preferred market in a rising rate environment. In fact, in September First Trust Advisors L.P. announced a dividend increase from $ per month to $ per month, starting with the dividend payable on October 15, Interest rate risk was managed by maintaining an effective duration, without including leverage, substantially lower than that of the blended index. 4, 5 The lower duration was accomplished with the assistance of derivatives throughout the first three quarters of the year; however, as Stonebridge continued to select securities that it believed would best perform in the current environment, duration naturally drifted lower. FPF ended the quarter with an effective duration without leverage of 4.34 years, only 0.02 years higher than the effective duration at the start of the quarter with a hedge, and 1.51 years lower than the blended index s effective duration of 5.86 years. The interest-rate hedge, used to manage duration, consisted of positions in Treasury futures and options on treasury futures. 6 FPF s duration, when including leverage and the hedge, was 6.37 years as of September 30, The 4.34 year duration without leverage is close to the lower end of the range of 3-7 years as per the FPF prospectus. The big story of the quarter for the preferred and hybrid securities market was the underperformance of fixed-to-floaters, many of which are institutional issues, relative to the general market. The reality is that not all fixed-to-floaters are alike and as a result, parts of the fixed-to-floater (F-T-F) market performed well and other parts underperformed. The parts of the F-T-F market that performed the worst during the third quarter were Contingent Convertible securities (CoCo s) and some F-T-F that have an unattractive spread to LIBOR if securities are not called. 7, 8 The F-T-F CoCo s, as represented by the Merrill Lynch Contingent Capital Index (COCO), had a total return for the quarter of -2.08%. Fortunately, the fund has maintained a small weighting in these securities, which have experienced volatility similar to that of high yield bonds. Leverage was decreased slightly during the third quarter from 31.5% to 31.3%. The impact of leverage on performance during the quarter was an increase in FPF s total return of 0.03% (based on NAV). Treasuries continued their rally in the third quarter, thus causing a loss in FPF s interest rate hedge. The impact of the small interest rate hedge placed on the fund s portfolio was -0.10% (based on NAV) during the third quarter. 3Q14 General Market Recap The third quarter of 2014 was a volatile and mixed period as geopolitical events, coupled with concerns about a global slowdown, drove a flight to quality around the world. Risk was off during the period as we saw a substantial tightening in the long and short end of the yield curve, while equity and credit markets were volatile. Within the preferred and hybrid space, July marked the first month of negative performance for the $25 par market in 2014 and September had the first month of negative performance for the $1000 par market. 9 Despite volatility across most markets, the preferred and hybrid market returned positive performance for the quarter, supported by global investor demand for yield and secondary issues, excess spread relative to Treasuries and corporates, and a lack of new issuance. During the third quarter, the preferred and hybrid market earned 0.31% and 0.29% (according to the BofA Merrill Lynch Preferred and Hybrid Indices, P0P1 and C0CS, respectively). 1

2 Figure 2. Hybrid Preferred Total Return Performance Relative to Other Indices Index Ticker Avg. Effective Rating 10 Duration 1Q14 2Q14 3Q14 BofA Merrill Lynch Fixed Rate Preferred Securities P0P1 BBB BofA Merrill Lynch US Capital Securities C0CS BBB BofA Merrill Lynch Contingent Capital COCO BB BofA Merrill Lynch US Corporate C0A0 A BofA Merrill Lynch US Cash Pay High Yield J0A0 B BofA Merrill Lynch Current 10-Yr US Treasury GA10 AAA BofA Merrill Lynch Current 30-Yr US Treasury GA30 AAA BofA Merrill Lynch US Mortgage Backed Securities M0A0 AAA BofA Merrill Lynch US Municipal Securities U0A0 AA BofA Merrill Lynch All US Convertibles ex Mandatory V0A S&P 500 SPX Source: Stonebridge Advisors LLC, BofA Merrill Lynch Research as of 9/30/14. This example is for illustrative purposes only and not indicative of the Fund. Past performance is no guarantee of future results. Negative headlines and economic weakness worldwide continue to be countered by accommodative central bank policy around the world and the stabilizing growth of the U.S. economy. In the U.S., while the Federal Reserve s (the Fed) asset purchase program stands ready to end in October, a rate hike is not expected until mid-to-late 2015, with the Fed maintaining its balance sheet by reinvesting proceeds for a longer time. The European Central Bank (ECB) continued to increase quantitative easing during the quarter with ECB President Mario Draghi pledging additional steps, including broad buying with the potential of investments in the European corporate bond market. Additionally, while 2014 output and GDP estimates for the U.S. were revised downward, 2015 expectations remained in line and U.S. GDP surprised to the upside during the third quarter. The U.S. unemployment rate hit 5.9% in September, the lowest since A Fed balance sheet expected to be larger for a longer period drove a continued reduction in analyst expectations for Treasury yields and continues support for long duration securities and the preferred and hybrid market, in our opinion. These positive economic and political developments helped to temper negative sentiment from a number of unrelated events around the globe, which acted as a catalyst to both equity and credit market performance during what is typically a quiet quarter. The conflicts between Russia and Ukraine and Israel and Hamas coupled with the rise of the ISIS threat, weighed on the markets. Scotland held a close referendum for independence from the U.K., followed by a push for the same from Catalonians. Asia had unrest as pro-democracy rallies increased. The Ebola outbreak went from an isolated event in Africa to a global threat with the first U.S. cases confirmed. We also saw a technical default in Argentina, and the parent of Banco Espirito Santo filed for bankruptcy, followed by a Portuguese bailout of the bank. Finally, one of the largest fund managers in the world saw its CIO resign, which resulted in a reshuffling of fixed-income mutual fund flows and a temporary disruption to the bond markets. These events around the world influenced the global flight to quality experienced throughout the third quarter, with top-down events trumping bottom-up valuations. These events, combined with concerns of a global slowdown and profit-taking throughout the quarter caused a general risk-off sentiment, best seen in the change in Treasury yields throughout the world, (see Figure 3). 11 In July, the International Monetary Fund (IMF) reduced its 2014 global growth estimate by 0.3% to 3.4% with particular weakness in the U.S., China and emerging markets. Even given a dramatic reduction in estimated 2014 U.S. output to 1.7% from 2.8% after the weak first quarter, and the removal of the biggest buyer of Treasuries from the market imminent with the end of the Fed s asset purchase program expected in October, the U.S. 10-year Treasury still managed to tighten. In the Treasury market, we saw the largest moves in Europe as the market became concerned about slowing growth (validated by the IMF stating that the probability of the EU going back into recession in the next six months has roughly doubled). Figure 3. Changes in Country 10-Year Yields Country Index Name 9/30/14 Q3 YTD United States US Generic Govt 10-Year Yield Canada Canadian Government Bonds 10-Year Note Brazil Federal Republic of Brazil United Kingdom UK Generic Govt 10-Year Yield France Government of France Germany Germany Generic Govt 10-Year Yield Italy Italy Generic Govt 10-Year Yield Spain Spain Generic Govt 10-Year Yield Japan Japan Generic Govt 10-Year Yield Australia Australia Govt Bonds Generic Yield Source: Stonebridge Advisors LLC, Bloomberg. Past performance is no guarantee of future results. 2

3 Despite these concerns, the preferred and hybrid market remained supported by credit fundamentals that continue to improve, particularly within the bank sector. As banks continue to work toward Basel III compliance and capital levels that should suffice in stressed conditions, U.S. and European bank improvements have been endorsed by the positive results of the Comprehensive Capital Analysis and Review (CCAR) in the U.S., and the ECB s Asset Quality Review (AQR) and stress test in Europe. 12 The European market had been particularly volatile leading into the ECB s results as there was much anticipation about stressed capital levels and possible issuance needs. The results revealed none of the major banking institutions in Europe failed the AQR, nor were deemed in need of additional capital under the stress test. During the third quarter, $1000 par securities slightly underperformed, largely influenced by the involvement of high-yield investors and the massive withdrawals seen in that market. CoCos led the market lower, driven by fast-money high-yield sellers, concerns about stress test results and their removal from broad-based BofA Merrill Lynch Indices. Lack of liquidity due to typical seasonal declines in the summer months was exacerbated by the increased inelasticity of dealer balance sheets. 13 The quarter ended on a strong note as investors continued to appreciate the accommodative central bank policy, continued improvement in credit fundamentals, and excess yield available in the preferred and hybrid market. Figure 4. Preferred Indices Returns for Select Periods by Effective Duration Bands P0P1 C0CS Duration Band (Years) Weighting 3Q 2014 TR Weighting 3Q 2014 TR Effective Duration [0-3] 17.67% -0.03% 29.62% 0.40% Effective Duration [3-5] 16.60% -0.26% 13.07% 0.11% Effective Duration [5-8] 29.54% 0.29% 35.25% -0.56% Effective Duration [8-12] 23.25% 0.94% 15.72% 1.91% Effective Duration [>=12] 12.79% 0.48% 6.17% 0.82% Grand Total % 0.31% % 0.29% Source: Stonebridge Advisors LLC, BofA Merrill Lynch Research. Past performance is no guarantee of future results. Investment Outlook Preferred and hybrid securities have been one of the best performing fixed-income asset classes year-to-date. Assuming the global financial markets remain stable, we believe this positive trend will likely continue through the end of the year. We also believe there will be a benefit to the market from the recent positive results of the ECB AQR and Stress Test, which should provide more stability to the European hybrid capital market going forward. The accommodative stance of global central banks continues to lead us to believe that we are likely to remain in a benign low-rate environment over the near term, which we anticipate will prove positive for preferred securities. The excess spread or yield built into preferreds relative to Treasuries and investment-grade corporates continues to prove attractive relative to most fixed-income asset classes and should provide support for preferreds through year-end, in our opinion. As the investment community continues to debate the direction and velocity of interest rates over the near term, we do not foresee any major catalysts that will cause rates to spike during the fourth quarter. With the Fed s end of QE priced in, the ECB implementing further quantitative easing in an attempt to jump start the European economy, and market expectations for the first rate hike 6 to 12 months away, we believe rates are likely to stay low globally over the near term. In our opinion, the low rate environment will be a positive for preferreds given the attractive yield of the product. Nonetheless, given how quickly rates moved last year, we believe maintaining a shorter duration than the blended index is the best way to position a portfolio, especially if one does not have to sacrifice yield on the portfolio. We anticipate that issuance in the fourth quarter will be on pace with the third quarter from both U.S. and European institutions, with banks dominating the majority of the new issue calendar. New issuance both in the U.S. and Europe has the potential of slightly re-pricing the market wider, especially if the market is subject to a large number of new issues over a short time frame. However, overall demand continues to be strong and we anticipate any repricing effect to be temporary. Preferreds and hybrids remain very attractive relative to other fixed-income asset classes due to their above average yields. The P0P1 Index currently yields 6.26% as of September 30, which is over 2% more than investment-grade corporates and less than 0.50% lower yielding than high yield corporates (see Figure 5). The C0CS Institutional Index yields 5.90%, 0.36% lower than P0P1, but consistently more yield than all other investment-grade asset classes. As we have noted previously, investors that choose to move further down the capital structure into preferreds and hybrids are being compensated with a higher yielding product. As investors continue to reach for yield in this low rate environment, we believe preferreds are likely to perform well relative to other fixed-income asset classes given their high yields and higher average credit quality of the issuers. 3

4 Figure 5. Comparison of Preferred Securities to Other Fixed-Income Asset Classes Index Ticker Avg. Current Effective OAS Rating 10 Yield (%) Duration BofA Merrill Lynch Fixed Rate Preferred Securities P0P1 BBB BofA Merrill Lynch Adjustable Rate Preferred Securities P0A0 BBB N/A N/A BofA Merrill Lynch US Capital Securities C0CS BBB BofA Merrill Lynch US Corporate C0A0 A BofA Merrill Lynch US Cash Pay High Yield J0A0 B BofA Merrill Lynch Current 10-Yr US Treasury GA10 AAA 2.40 N/A 8.94 BofA Merrill Lynch Current 30-Yr US Treasury GA30 AAA 3.16 N/A BofA Merrill Lynch US Mortgage Backed Securities M0A0 AAA BofA Merrill Lynch US Municipal Securities U0A0 AA Source: Stonebridge Advisors LLC, BofA Merrill Lynch Research as of 9/30/14. This example is for illustrative purposes only and not indicative of the Fund. Past performance is no guarantee of future results. Figure 6 shows the historical spread of P0P1 to the 10-year Treasury over the past 17 years. The current spread is 3.86%, which is approximately 0.40% wide of the 17-year historical average of 3.48%. However, if you segment the time periods to pre-credit crisis and post-credit crisis periods, you can see preferreds traded much tighter on average prior to the credit crisis. The financial sector s heightened regulation coupled with significantly improved capitalization for the banking industry leads us to believe that there is room for further spread compression of preferreds back to pre-crisis levels. This implies that we may have room for further appreciation of the asset class in this low-rate environment and, alternatively, may provide a cushion against a future rise in rates. Figure 6. Historical Spread of Preferred Securities to 10-Year Treasury Yield P0P1 Yield GA10 Yield Average Spread 3.48% 12/31/1997 9/30/2014 Average Spread 2.66% Average Spread 4.55% 12/31/1997 7/31/2007 7/31/2007 9/30/2014 Current Spread 3.86% % % 0 12/31/1997 6/30/ /31/1998 6/30/ /31/1999 6/30/ /31/2000 6/30/ /31/2001 6/30/ /31/2002 6/30/ /31/2003 6/30/ /31/2004 6/30/ /31/2005 6/30/ /31/2006 6/30/ /31/2007 6/30/ /31/2008 6/30/ /31/2009 6/30/ /31/2010 6/30/ /31/2011 6/30/ /31/2012 6/30/ /31/2013 Source: Merrill Lynch, Bloomberg, Stonebridge Advisors LLC. This example is for illustrative purposes only and not indicative of the Fund. Past performance is no guarantee of future results. 9/30/2014 4

5 Investment Objective/Strategy First Trust Intermediate Duration Preferred & Income Fund is a non-diversified, closed-end management investment company. The Fund's primary investment objective is to seek a high level of current income. The Fund has a secondary objective of capital appreciation. The Fund seeks to maintain, under normal market conditions, a duration excluding the effects of leverage, of between three and eight years. Under normal market conditions, the Fund will invest at least 80% of its Managed Assets in a portfolio of preferred and other income-producing securities. The Fund also will invest at least 25% of its Managed Assets in the group of industries that are part of the financials sector as classified under the Global Industry Classification Standards developed by MSCI, Inc. and Standard & Poor's, which is currently comprised of banks, diversified financials, real estate (including real estate investment trusts) and insurance industries. Under normal market conditions, the Fund will seek to invest in a portfolio of securities that has an average weighted investment grade credit quality. The Fund, for enhanced income potential, will also invest in below investment-grade securities. These securities are commonly referred to as junk or high-yield securities and are considered speculative with respect to the issuer's capacity to pay interest and repay principal. Performance Summary as of 9/30/2014 Cumulative Total Returns Period Share Price NAV 3 Months -3.05% 0.19% Year to Date 7.97% 10.96% 1 Year 11.02% 15.63% Average Annual Total Returns Period Share Price NAV 3 Years N/A N/A 5 Years N/A N/A Since Inception (5/23/13) -2.83% 9.39% Total return is the combination of reinvested dividend income and reinvested capital gains distributions, at prices obtained by the Dividend Reinvestment Plan, if any, and changes in the NAV and Share Price. The NAV total return takes into account the Fund s total annual expenses and does not reflect sales load. Performance would have been lower if a sales load would have been applied. Performance data quoted represents past performance. Past performance is not a guarantee of future results and current performance may be higher or lower than performance quoted. Investment returns and principal value will fluctuate and shares when sold, may be worth more or less than their original cost. The NAV represents the Fund s net assets (assets less liabilities) divided by the Fund s common shares outstanding. Fund shares are purchased and sold on an exchange at their share price rather than NAV, which may cause the shares to trade at a price greater than NAV (premium) or less than NAV (discount). Risks and Considerations The fund is subject to risks, including the fact that it is a non-diversified closed-end management investment company. Shares of closed-end investment companies frequently trade at a discount from their net asset value. Investment return and market value of an investment in the fund will fluctuate. Shares, when sold, may be worth more or less than their original cost. Preferred/hybrid and debt securities in which the fund invests are subject to various risks, including credit risk, interest rate risk, and call risk. Credit risk is the risk that an issuer of a security will be unable or unwilling to make dividend, interest and/or principal payments when due and that the value of a security may decline as a result. Credit risk may be heightened for the fund because it invests in below investment grade securities, which involve greater risks than investment grade securities, including the possibility of dividend or interest deferral, default or bankruptcy. Interest rate risk is the risk that the value of fixed-rate securities in the fund will decline because of rising market interest rates. Call risk is the risk that performance could be adversely impacted if an issuer calls higher-yielding debt instruments held by the fund. Because the fund is concentrated in the financials sector, it will be more susceptible to adverse economic or regulatory occurrences affecting this sector, such as changes in interest rates, loan concentration and competition. Investment in non-u.s. securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries. Use of leverage can result in additional risk and cost, and can magnify the effect of any losses. The risks of investing in the fund are spelled out in the prospectus, shareholder report and other regulatory filings. 5

6 Footnotes: 1 A fixed-to-floating rate security has a coupon rate that is fixed for a certain period of time (typically five, ten or thirty years from the time of issuance), after which the coupon resets at a floating rate based on a spread over the security s benchmark (typically 3-month LIBOR). 2 $1000 par ( institutional ) securities are issued and trade in denominations of $1000. They are typically traded over the counter (OTC), and generally have income accrued daily separate from the market price, similar to corporate bonds. 3 Distribution rates are calculated by annualizing the most recent distribution paid or declared through the end of the quarter and then dividing by the quarter-end market price. The distribution consists of the sum of net investment income, net realized short-term capital gains, net realized long-term capital gains, and return of capital. Distribution rates may vary. Any distribution adjustment will not be reflected until after the declaration date for the next distribution. See the fund's 19a-1 Notices, if any, located under the "News & Literature" section of the website for estimates of distribution sources. Final determination of the source and tax status of all distributions paid in the current year will be made after year-end. 4 Duration/Interest rate risk is a measure of a security s sensitivity to interest rate changes that reflects the change in a security s price given a change in yield. 5 Leverage is a technique where a fund s manager borrows assets at one rate and invests the proceeds from the borrowed assets at another rate, seeking to increase yield and total return. Use of leverage can result in additional risk and cost, and can magnify the effect of any losses. 6 Futures are a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset) at a predetermined future date and price. 7 Contingent Convertible securities (CoCo s) are a specific type of security similar to traditional convertible bonds. Unlike traditional convertible bonds, the possibility of converting a CoCo bond to equity is contingent and will occur only in the case of a specific event that can be different depending on the particular need of an issuer. 8 LIBOR is a benchmark rate that some of the world's leading banks charge each other for short-term loans. 9 $25 par ( retail ) securities are issued and trade in denominations of $25. They are generally listed and traded on the NYSE, have accrued income embedded within the market price, and coupons are only received if security is owned on record date, similar to common stocks. 10 The ratings are by Standard & Poor s. A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO), of the creditworthiness of an issuer with respect to debt obligations. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest). Investment grade is defined as those issuers that have a long-term credit rating of BBB- or higher. 11 Risk-on risk-off refers to changes in investment activity in response to global economic patterns. During periods when risk is perceived as low, risk-on risk-off theory states that investors tend to engage in higher-risk investments, thus maintaining a risk-on sentiment. When risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments, thus maintaining a risk-off sentiment. 12 Basel III refers to a comprehensive set of reform measures designed to improve the regulation, supervision and risk management within the banking sector. 13 Inelastic means that when the price goes up, consumers buying habits stay about the same, and when the price goes down, consumers buying habits also remain unchanged. 14 Option-Adjusted Spread (OAS) is a measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Index Definitions: P0P1 BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate US dollar-denominated preferred securities issued in the US domestic market. P0A0 BofA Merrill Lynch Adjustable Rate Preferred Securities Index tracks the performance of adjustable-rate US dollar-denominated preferred securities issued in the US domestic market. C0CS BofA Merrill Lynch US Capital Securities Index a subset of the BofA Merrill Lynch US Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities. C0A0 BofA Merrill Lynch US Corporate Index tracks the performance of US dollar-denominated investment-grade corporate debt publicly issued in the US domestic market. J0A0 BofA Merrill Lynch US Cash Pay High Yield Index tracks the performance of US dollar-denominated below investment-grade corporate debt, currently in a coupon-paying period, that is publicly issued in the US domestic market. GA10 BofA Merrill Lynch Current 10-Year US Treasury Index is a one-security index comprised of the most recently issued 10-year US Treasury bond. GA30 BofA Merrill Lynch Current 30-Year US Treasury Index is a one-security index comprised of the most recently issued 30-year US Treasury bond. M0A0 BofA Merrill Lynch US Mortgage Backed Securities Index tracks the performance of US dollar-denominated fixed-rate and hybrid residential mortgage pass-through securities publicly issued by US agencies in the US domestic market. U0A0 BofA Merrill Lynch US Municipal Securities Index tracks the performance of US dollar-denominated investment-grade tax-exempt debt publicly issued by US states and territories, and their political subdivisions, in the US domestic market. V0A0 BofA Merrill Lynch All US Convertibles ex Mandatory Index tracks the performance of convertible securities of all corporate sectors with a par amount of $25 million or more and a maturity of at least one year and excludes preferred equity redemption stocks and converted securities. SPX S&P 500 Index The S&P 500 Index is an unmanaged index of 500 stocks used to measure large-cap U.S. stock market performance. COCO BofA Merrill Lynch Contingent Capital Index tracks the performance of all contingent capital debt publicly issued in the major domestic and Eurobond markets, including investment-grade and sub-investment-grade issues. Indexes are unmanaged and an investor cannot invest directly in an index. 6