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Preface

In my weekly CEF update of July the 2nd, I mentioned PIMCO High Income Fund (PHK) as a focus stock for the reason I couldn’t understand its valuation relative to its high yield peer group(s). I queried whether anyone had any insight as to why it was trading as it was. I received some thoughtful replies regarding others' befuddlement. The following is a formal argument why its valuation appears faulty.

Summary

Based upon publicly available information, the shares of PIMCO High Income Fund (PHK) appear greatly overvalued relative to its closed end fund (CEF) peer group and ETFs specializing in high yield securities. (PHK is being removed from the Eqcome CEFBig10™ Portfolio and is being replaced with Western Asset High Income Fund II (HIX).)

Valuation Estimate

The stock of PHK should be trading closer to $6.00 a share. This would be approximately a 30% reduction from its current price. This estimate is based upon: 1) its current unsustainable excess premium relative to its peers; 2) a projected reduction in cash flow leading to a potential decrease in its distribution level.

The latter is based upon the recent changes in its investment strategy, portfolio leverage and the potential near-term deterioration of the high yield securities markets in a sluggish US economy recovery.

One-Two Punch for Disaster

The recent success of high yield funds’ price appreciation and tentative high distribution yields are luring retail investors as they chase both performance and yield.

Recommendation

Owners of PHK may want to take this opportunity to sell a major portion of their position and switch into a high yield ETF that is trading closer to par, doesn’t employ leverage and whose expense ratio is a quarter of the CEFs’ average. I wouldn’t recommend shorting the stock (PHK) due to the continuing monthly dividend obligation associated with such action and the difficulty in finding the stock to short. More sophisticated investors can calculate those factors into their investment decision.

Background

PHK is a CEF that invests in a diversified portfolio of U.S. dollar obligations and other income producing securities that are primarily rated below investment grade. Its primary objective is to seek high current income with a secondary objective of capital appreciation.

Numbers Don’t Seem to Make Sense

Based upon multiple publicly available metrics for comparable CEFs and ETFs, the numbers for PHK don’t appear to makes sense given its current valuation. The follow are 6 points that argue this position.

Point 1: PHK is paying a monthly dividend of $.1219 per share for an annualized rate of $1.46. This implied a distribution yield of 16.2% versus 11.9% average for its 21 CEF high yield peer group. Yet, the stock is trading at a 55.3% premium versus its peer group’s average premium of 3.1%. When compared with three ETFs that invest in junk bonds: HYG; JNK; PHB, its average distribution yield is 11.6% and trade at a slight average discount of 1.1%.

Further narrowing PHK’s peer group (depicted in chart) to high yield CEFs that are leveraged with auction rate preferred securities (ARPS), the increase in the premium of PHK versus its comparables appears abnormally high even considering the run-up in the high yield market segment. (See chart below.)

From Sept 30, ’08 to July 6th 2009, PHK sustained comparable price increases versus an asset weighted price index of 3 ARPS leveraged CEF (Sept 30, 2008 = 1.00; 1.28 versus 1.34, respectively). This would indicate that PHK’s recent stock appreciation wasn’t attributable to “catch-up” price performance.

Based upon average premium/discount comparables for both CEFs and ETFs, that are trading close to par, if PHK was selling at par (i.e. the share price and NAV are equal), PHK would be trading at 5.82 per share; or, at a 35.6% discount to its current price ($9.04).

Point 2: Let’s assume that PHK is generating its distribution yield based on net investment income. Therefore, if PHK is generating a 16.2% distribution yield based on an unleveraged portfolio at a 55.3% premium, then PHK would be generating a 24.3% current yield on its unleveraged portfolio based upon its par value.

As a check on this implied portfolio yield, the current yield on high yield junk bonds according to the Merrill Lynch High Yield Masters II Index, was approximately 13% for the month of June ‘09. If you applied the spread between this yield and the cost of PHK’s ARPS, it would generate another 5.7% return from leverage, or a total portfolio yield of 18.7% at best.

Another check would be that PHK’s average coupon was 7.18% based upon May 30th 2009 annual report. If you assume PHK purchased the investments at record low price of $56.80, on par value of 100, it would indicate an unleveraged portfolio yield of 12.6%. This would be close to our assumption of a 13% unleveraged return noted above.

Point 3: PHK will likely be losing its leveraged return as it continues to buy back its ARPS through the sale of assets. During its fiscal year ending March 31, 2009, PHK repurchased $563 million of ARPS, reducing its leverage to comply with regulatory ratio allowing it to pay its distribution to common shareholders. Further reduction of leverage would likely reduce portfolio returns and ultimately the cash flow from the portfolio and net investment income payable to common shareholders. (Of course, PHK would elect to distribute capital gains or a return of capital to maintain the current rate.)

Point 4: There has been a significant appreciation in the value of high yield debt obligations as investors have become more willing to assume risk in a low interest rate environment. High yield bond funds were up 23% for the first half of 2009. CEF high yield fund types are up a whopping 46.9% year-to-date. While the high yield sector still provides an attractive yield at 13.0%, it is far less than the yield of 21.7% peak in November of last year.

There are several reasons to be nervous about chasing high yield funds at this juncture:

  1. A weaker economic recovery could cause the value of high yield paper to decline;
  2. The significant roll-over of junk bonds over the next two years could cause more supply thereby diluting values;
  3. Institutional investors cashing-out their high yield gains over the near-term;
  4. The combination of the above factors would cause an increase in the level of defaults.

Point 5: PHK has undertaken management, investment and capital structure policy changes. While the legendary Bill Gross is taking over the helm on a day-to-day basis, you still can’t turn a sow’s ear into a silk purse. The fact that PHK is increasing its limits on illiquid securities may be in anticipation of the issuance of non-liquid, equity securities in return for workouts of defaulted junk bonds.

A change in management and investment policy is always a good cover for a cut in the distribution level. I’d anticipate a cut prior to year end.

Point 6: There has been no insider buying of PHK. The last insider purchases where in October of last year when Bill Gross purchased 7,000 shares at $11.29. This is not the kind of investment enthusiasm I’d like to see for an individual who just took over responsibility for the success of the company.

Caveats

This article represents a “Level I” analysis. It examines the “large molecule” investment aspects of PHK. No detail analysis has been undertaken regarding its current portfolio, recent trading strategies or its hedging positions. On further analysis of these items, it may be found such factors would support its current stock price valuation.

Disclosure: Neither long nor short PHK or HIX

Source: PIMCO High Income Fund: Substantially Overvalued?