In the current low interest rate environment, gullible investors often pay too much for income generating financial instruments. One example of this phenomenon is the recent premium to net asset value recorded for the Pimco High Income Fund (PHK). Barron's noted several months ago that the premium to net asset value (NAV) for this closed end fund had reached 70%. This means investors were paying $1.70 for each dollar in underlying bonds held by the fund. On Friday, the market price of the fund closed at $10.82, a 28.8% premium to the current NAV of $8.40.
When a financial instrument sells off so brutally, it is worth kicking the tires to see if there is any underlying value that has become available at a bargain price. The figure below shows the premium to net asset value versus the market price of the fund over the previous ten years.
Several concerns should be noted. First, it is clear from the chart above that the financial crisis caused unrecoverable losses to the net asset value of the fund. Most likely, the fund owned high yield bonds issued by major banks that went bust during the financial crisis. Currently, the fund owns a fair number of bonds issued by Bank of America (BAC) among others; a careful reading of the prospectus is worthwhile to see what you are buying.
As a result of the losses in 2008, the previous NAV of $15 is never going to be recovered. In the fund's defense, any high income fund will experience erosion of its NAV over time. As junk bonds are often not recovered at par, loss of capital is inflicted. This is offset by the greater distribution or risk-premium offered by higher yielding bonds, but the net effect for a closed-end fund is erosion of the net asset value over time.
A second concern is that due to these unrecoverable losses and the desire of the fund manager to maintain the distribution of the fund, return of capital has been utilized. When the fund held $15 of high-income bonds in 2003, it was not difficult to generate $0.128 per monthly distribution (corresponding to a 10% return per year). Since there is no free lunch, the drawback is that the NAV has been reduced to $8.40 or by 44%. At this net asset value, there is no way the fund manager can generate the same distribution yield. As a result, to maintain the distribution, the fund has been returning capital to pay distributions. As seen below, 30% of the fund's distribution comes from a return of capital. Ultimately, this means that the fund's NAV will diminish over time even more than simple default of high yield bonds would anticipate.
At present, 30% of the yield is return of capital. The only point to be made is the 14.5% distribution yield must be taken with a grain of salt (this calculation is from the NAV price; it is lower at the market price: the distribution is 13.5% at the current market price with 9.5% not coming from return of capital). Thus when the fund is selling at its NAV, it generates a 9.5% return or 8.3% at the current market price.
With those unfavorable elements out in the open, is there a case that can be made for investing in Pimco's High Income Fund? This case greatly depends on the premium to net asset value. The average premium that the fund has enjoyed since its inception is 10%, while the premium since Lehman collapsed has been significantly greater at nearly 31%. Investors have clearly been willing to pay up for the added return. In my opinion, the maximum premium to net asset value that should be paid is ~10%. Pimco does have advantages that a smaller investor in bonds does not. For example, it has access to very low interest rates to lever the fund and is clearly better able to select and purchase a diversified portfolio of high yield bonds than would be possible for most investors through the purchase of individual bonds. These advantages are worth something, but it is difficult to argue that they are worth more than a 10% premium.
Whether the fund is a good investment at the present time also is determined by the direction of the economy. During poor economic times, investors pay more for safe bonds at the expense of risky ones. At the present time, the risk premium is lower and headed down. If the U.S. economy continues to avoid a recession, it is likely that the risk premium will narrow further and the rally in junk-rated debt may have room to run yet. However, the premium of the fund has diminished substantially even as junk bonds have rallied. This is fairly unusual as selling pressure in the fund last year was caused by a widening risk premium. It is worth remembering that a widening risk premium could put further pressure on the fund.
As outlined above, the brutality of the current sell-off in Pimco's High Income Fund may soon present a favorable entry price. The price must be less than $9.50/share and in order to get such a price, you will need to be willing to buy into a selling panic. The current downtrend has been punctuated by two vicious bouts of selling. Interestingly, last year's sell-off had three bouts of selling each of which made a lower low before prices recovered. Further selling pressure could put my $9.50/share target into play.
In conclusion, while high yield bonds are expensive historically, they are inexpensive relative to 'safe-haven' bonds. If you are constructive on the U.S. economy, high yield is a reasonable play and can provide additional income compared to stocks with a chance for capital appreciation in an improving economy. Closed-end funds are an interesting way to approach this investment thesis, but they are certainly high on the risk spectrum. It is expected that within the next several months, the premium to net asset value of Pimco's High Income Fund will begin to revert to the mean. If this occurs, it will result in excellent capital gains and distribution income, provided that an appropriate entry point is selected.
Disclaimer: The above analysis should not be considered a solicitation to buy the mentioned security. As always please perform your own due diligence before taking a long position in any stock or fund.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PHK over the next 72 hours.