PIMCO High Income Fund Still Defies Gravity 12 comments
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There appears no basis of support for PIMCO High Income Fund's (PHK) current share price other than a distribution yield that is increasingly becoming suspect. A significant source of PHK’s net investment income has come from its leverage which it has and is committed to reduce.
I have written about my concerns here before and I’ve received more comments regarding other investors coming to the same conclusion. (See: PIMCO High Income Fund: Substantially Overvalued?) PHK’s supporters note the legendary Bill Gross’s prowess in the fixed income markets and how PHK is now more of a trading company than an investment company. This is more of a conclusion in search of the facts.
In a Wall Street Journal article on July 21, 2009, entitled, “Investors Beware: Closed-End Funds Trading at a Premium”, Maury Fertig, a CEF expert and a founding partner of Relative Value Partners in NYC is quoted on PHK as follows:
Consider the PIMCO fund. The shares have a distribution yield of about 17%. That looks great. But it’s not the whole story. About 90% of the fund is invested in bonds rated BBB or below, which means they involve some risk of default. About a fifth of the fund is invested in long-dated bonds due to mature in more than 10 years. Those are at risk from inflation. Furthermore the fund is heavily levered: It has borrowed about 45 cents against every dollar of investments. That’s great when borrowing rates are low, as they are now - when rates rise, earnings will be squeezed.
To dispel the fears of all investors coming to the same conclusion that PHK is significantly overvalued, I would urge one of its more conversant supporters to provide some simple math on how PHK is going to be able to support a 16.5% distribution yield while trading at a 51% premium to its NAV.
I don’t see how it can defy the very powerful “gravitation towards the mean” that is inherent in CEFs. PHK is the equivalent of Jerry Seinfeld’s “the roommate switch”. It has never been done in the history of mankind.
Disclosure: I’m currently not short PHK, but may be at some future point in time.
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This is a complicated entity to understand, and I'm not an accountant. For example, I'm not sure what the negative Market Value line items mean in their holdings report. Is that a short sale, or something more bizarre? I can see some items with negative share <i>and</i> negative market values, which must surely be short positions, but then others with positive share values and negative market values.
But looking at the bottom line as of June 30:
Account Market Value: $990,006,900.20
(see www.allianzinvestors.c...)
Outstanding shares are 118 Million
(see: www.allianzinvestors.c...)
Which puts the portfolio value itself at $8.38 ($990 / 118).
However, their performance page puts the NAV at 5.84 with a footnote that says:
"Net asset value (NAV) is total assets less total liabilities divided by the number of shares outstanding."
(see: www.allianzinvestors.c...)
Well, we have the total assets in the Assets PDF, but where are the liabilities reported? The PDF has negative numbers in the bottom line, mostly in the futures line which are already accounted for in the total assets line. One should presume liabilities are the debt owed to whomever is providing the funds for leverage. I can't find that data.
Regarding leverage, WSJ suggested they are 45% leveraged, but Allianz disclosed the fund as only 31% leveraged.
(see: www.allianzinvestors.c...)
I can't tell if this is coincidence or the explanation for the divergence from NAV, but if you subtract the NAV (5.84) from the portfolio total assets per share (8.38) you get 2.54, which is around 30% of the asset values and about the same as reported leverage.
I looks like the market price is reflecting the leveraged asset value without accounting for the liabilities behind those assets. But if the WSJ was using old data in their leverage quote, then leverage is decreasing while NAV is rising.
(see "High/Low Ranges - One Year (as of 06.30.09) ": www.allianzinvestors.c...)
As for junk bonds, the portfolio is moving out of them, too, which is in line with their public posturing.
(see credit quality table, <B down to 15%: www.allianzinvestors.c...)
Like any large portfolio, one can't simply sell everything the day after you publish a report, nor wait until you are 100% divested and then tell your listening audience about it.
There are two reasons I own PHK: Bill and Ben. Bill Gross' skill, both financial and political, and Ben Bernanke's market making operations in the credit market. In particular, I'm expecting capital gains as the fund sells some of those illiquid assets to the new PPIP market which only recently started coming together (see July 9th press release: www.financialcrisisupd.../)
There was talk that PIMCO would be one of the partners, but it might be the case they are better off selling into the PPIP those assets they acquired in the worst of the market turmoil to the new players in the game, rather than being the buyer in a rising market.
While I can't get access to daily trading information in PHK, I'm looking for the NAV and portfolio asset values to rise around the time the news services start reporting insights into how this PPIP market is developing. If PPIP is running full throttle and PHK isn't realizing NAV gains during that period, then the presumed windfall will be discredited in my mind, and I'll have to give up the fantastic income from this position. The premium is my price for getting a piece of the action by proxy, otherwise granted only by government for the privileged few.
And the fact that PIMCO is involved in this murky little deal is ironic since they should be promoting the rights of individual bondholders - many of them being their customers.
You cannot confuse (or match) his advice with his offerrings.
Thank you for your thoughtful and meticulously documented comment.
It sounds to me that we agree that the NAV, after subtracting the related debt, is around $5.84 per share for the common shareholders; and, you concur that the stock is trading at a 51% premium to its NAV.
For those who are betting on Bill Gross, that’s fine. Folks like you, who are knowledgeable, have made that evaluation based on the expertise of the managers and are willing to take a calculated investment risk.
My concern is for those retail investors who are chasing yields and are unaware that there is no empirical evidence to support PHK’s current stock valuation over an extended period of time based upon its current premium to NAV.
Additionally, retail investors seeking yield may not understand PHK’s prospective income stream is likely to be of lesser quality (capital gains as opposed to net investment income) and more volatile (timing of capital gains).
We need someone to provide us with a “chalk talk” regarding the pro forma NAV with respect to: 1) the value of its derivative products currently not be imputed into the NAV due to current GAAP accounting standards; 2) the discounted future capital gains from the execution of their trading program.
In the absence of that disclosure, income investors are operating in the realm of speculation and may be better off in a different CEF.
Joe Eqcome
On Jul 23 11:21 AM Jade Bond wrote:
> Good article Joe. Maybe investors are simply using the net assets
> divided by outstanding shares rather than NAV.
>
> This is a complicated entity to understand, and I'm not an accountant.
> For example, I'm not sure what the negative Market Value line items
> mean in their holdings report. Is that a short sale, or something
> more bizarre? I can see some items with negative share <i>and</i>
> negative market values, which must surely be short positions, but
> then others with positive share values and negative market values.
>
>
> But looking at the bottom line as of June 30:
> Account Market Value: $990,006,900.20
> (see www.allianzinvestors.c...)
>
>
> Outstanding shares are 118 Million
> (see: www.allianzinvestors.c...)
>
>
> Which puts the portfolio value itself at $8.38 ($990 / 118).
>
> However, their performance page puts the NAV at 5.84 with a footnote
> that says:
>
> "Net asset value (seekingalpha.com/symbo...) is total assets
> less total liabilities divided by the number of shares outstanding."
>
> (see: www.allianzinvestors.c...)
>
>
> Well, we have the total assets in the Assets PDF, but where are the
> liabilities reported? The PDF has negative numbers in the bottom
> line, mostly in the futures line which are already accounted for
> in the total assets line. One should presume liabilities are the
> debt owed to whomever is providing the funds for leverage. I can't
> find that data.
>
> Regarding leverage, WSJ suggested they are 45% leveraged, but Allianz
> disclosed the fund as only 31% leveraged.
> (see: www.allianzinvestors.c...)
>
>
> I can't tell if this is coincidence or the explanation for the divergence
> from NAV, but if you subtract the NAV (5.84) from the portfolio total
> assets per share (8.38) you get 2.54, which is around 30% of the
> asset values and about the same as reported leverage.
>
> I looks like the market price is reflecting the leveraged asset value
> without accounting for the liabilities behind those assets. But if
> the WSJ was using old data in their leverage quote, then leverage
> is decreasing while NAV is rising.
> (see "High/Low Ranges - One Year (as of 06.30.09) ": www.allianzinvestors.c...)
>
>
> As for junk bonds, the portfolio is moving out of them, too, which
> is in line with their public posturing.
> (see credit quality table, <B down to 15%: www.allianzinvestors.c...)
>
>
> Like any large portfolio, one can't simply sell everything the day
> after you publish a report, nor wait until you are 100% divested
> and then tell your listening audience about it.
>
> There are two reasons I own PHK: Bill and Ben. Bill Gross' skill,
> both financial and political, and Ben Bernanke's market making operations
> in the credit market. In particular, I'm expecting capital gains
> as the fund sells some of those illiquid assets to the new PPIP market
> which only recently started coming together (see July 9th press release:
> www.financialcrisisupd.../)
>
>
> There was talk that PIMCO would be one of the partners, but it might
> be the case they are better off selling into the PPIP those assets
> they acquired in the worst of the market turmoil to the new players
> in the game, rather than being the buyer in a rising market.
>
> While I can't get access to daily trading information in PHK, I'm
> looking for the NAV and portfolio asset values to rise around the
> time the news services start reporting insights into how this PPIP
> market is developing. If PPIP is running full throttle and PHK isn't
> realizing NAV gains during that period, then the presumed windfall
> will be discredited in my mind, and I'll have to give up the fantastic
> income from this position. The premium is my price for getting a
> piece of the action by proxy, otherwise granted only by government
> for the privileged few.
I suspect it revolves around value of bonds based on cash flow and expected defaults. I think you summarized what I was thinking -- that the portfolio needs a comprehensive analysis of each holding, summed together to come up with a market value.
My back of the napkin calculations show that given a NAV yield of 25.43% (www.allianzinvestors.c...), the fund would have to experience a 50% default rate and 0% recovery rate to normalize it's NAV to a historical yield of 12% for high-yield investment grade bonds (S&P classifies investment grade bonds as BBB or higher, and Moodys' classifies investment grade bonds as Ba or higher).
25% yeild is just crazy. I don't think 30% leverage is sufficient to explain that much yeild. Many of those bonds must be priced at rediculous default and recovery assumptions for that kind of cash flow. You might remember the phrase, "Beware, I have a gun and know how to us it." In this case, I think Bill Gross could say, "Beware, I have a Bloomberg terminal and I know how to use it."
Now some Mad Max economic scenarios would argue for just such default rates, but the fact is we are unlikely to see that kind of default and recovery, at least not with the managment team of Pimco. I'm not saying they are perfect and can't make some bad bets, but 50% and 0% is a pretty darn huge assumption for this calibre of fund managment.
One would have to be crazy not to buy this fund at NAV. We should hope for such crazy pricing -- I'd readly double-down on this fund if the only news event was the price dropped to NAV and the rest of the banking system handn't also collapsed.
On Jul 23 01:39 PM Joe Eqcome wrote:
> Jade Bond
>
> Thank you for your thoughtful and meticulously documented comment.
>
>
> It sounds to me that we agree that the NAV, after subtracting the
> related debt, is around $5.84 per share for the common shareholders;
> and, you concur that the stock is trading at a 51% premium to its
> NAV.
>
> For those who are betting on Bill Gross, that’s fine. Folks like
> you, who are knowledgeable, have made that evaluation based on the
> expertise of the managers and are willing to take a calculated investment
> risk.
>
> My concern is for those retail investors who are chasing yields and
> are unaware that there is no empirical evidence to support PHK’s
> current stock valuation over an extended period of time based upon
> its current premium to NAV.
>
> Additionally, retail investors seeking yield may not understand PHK’s
> prospective income stream is likely to be of lesser quality (capital
> gains as opposed to net investment income) and more volatile (timing
> of capital gains).
>
> We need someone to provide us with a “chalk talk” regarding the pro
> forma NAV with respect to: 1) the value of its derivative products
> currently not be imputed into the NAV due to current GAAP accounting
> standards; 2) the discounted future capital gains from the execution
> of their trading program.
>
> In the absence of that disclosure, income investors are operating
> in the realm of speculation and may be better off in a different
> CEF.
>
> Joe Eqcome
Thank you for your amusing comment.
I’m always entertained by those who revert to name calling when they have no basis of support for their position—they’re usually the ones losing the argument.
Rather than resorting to name calling and casting dispersions, why don’t you provide us with some facts to rebut my contentions? Do you have any? I didn’t think so.
Judging from the comments in my original article, the WSJ article and the comments in this article, I’d say there are more people expressing my sentiment then your view.
Please provide us some counter arguments or stop wasting electron with this amateurish drivel as no one is following your comments (0) anyway.
Joe Eqcome
On Jul 23 03:59 PM amorgano wrote:
> How much longer are we going to have to put up with this bullcrap...as
> you read the above most all us are sophisticated investors and are
> well aware of the facts of this fund so we don't have to be told
> every week...and get your facts straight before you publish them
> or you will have fewer readers or none at all....go short if you
> are such a negative believer...it will be nice to see you squeezed...you
> are a negative ball and chain for Seeking Alpha......
I want to make sure we understand the numbers you’re proffering.
The NAV yield of 25.43% you noted is no more than the annualized dividend of $1.4628 per share divided by the NAV per share of $5.75 at the end of June (the date on which the calculation is based). This is not to be confused with net investment income being generate on the portfolio after debt service. (As a check, if you were to take the dividend and divide by the share price at the end of June you get 16.36%--the same as on their website.)
So, the portfolio is not likely yielding 25.43% based on net investment income.
As I outlined in my original article, PHK reported its average coupon was 7.18% based on its 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%. 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 18.3% at best on NAV.
Additionally, on your hyperlink to PHK’s site, the auction rate page showed the cost for PHK’s auction rate preferred securities averaging 25 basis points. Not only will that rate not last forever, PHK has been deleveraging.
I’m not seeing anything that provides me with comfort that PHK is generating enough net investment income to sustain its current distribution level on that basis. While it could temporarily support the distribution level with capital gains and return of capital, distribution would be of lesser quality.
And as I articulated here before, there is no precedent for a CEF maintaining a premium of 50% to NAV over an extended period of time.
I would like to have someone provide some numbers that would result in a different conclusion. I'm open to being convinced differently. I just haven't seen any.
The fact are coming together very poorly for PHK stockholders.
For the purpose of full disclosure, I shorted the stock today.
Joe Eqcome.
On Jul 23 06:21 PM Jade Bond wrote:
> Yes, I think we agree at some level. On the way into work today I
> was thinking about the math you requested. I wish I could provide
> it, but I don't have the tools for bond price analysis. I don't even
> have a Bloomberg terminal! ;-(
>
> I suspect it revolves around value of bonds based on cash flow and
> expected defaults. I think you summarized what I was thinking --
> that the portfolio needs a comprehensive analysis of each holding,
> summed together to come up with a market value.
>
> My back of the napkin calculations show that given a NAV yield of
> 25.43% (www.allianzinvestors.c...),
> the fund would have to experience a 50% default rate and 0% recovery
> rate to normalize it's NAV to a historical yield of 12% for high-yield
> investment grade bonds (S&P classifies investment grade bonds
> as BBB or higher, and Moodys' classifies investment grade bonds as
> Ba or higher).
>
> 25% yeild is just crazy. I don't think 30% leverage is sufficient
> to explain that much yeild. Many of those bonds must be priced at
> rediculous default and recovery assumptions for that kind of cash
> flow. You might remember the phrase, "Beware, I have a gun and know
> how to us it." In this case, I think Bill Gross could say, "Beware,
> I have a Bloomberg terminal and I know how to use it."
>
> Now some Mad Max economic scenarios would argue for just such default
> rates, but the fact is we are unlikely to see that kind of default
> and recovery, at least not with the managment team of Pimco. I'm
> not saying they are perfect and can't make some bad bets, but 50%
> and 0% is a pretty darn huge assumption for this calibre of fund
> managment.
>
> One would have to be crazy not to buy this fund at NAV. We should
> hope for such crazy pricing -- I'd readly double-down on this fund
> if the only news event was the price dropped to NAV and the rest
> of the banking system handn't also collapsed.
>
> On Jul 23 01:39 PM Joe Eqcome wrote:
Seriously, though, I did some deep digging in the annual report this weekend as I like your point about finding the cash behind the payout. Boy, there is some JUICY cash flow in this portfolio, and I don't see it in the ARS market.
While I still haven't found the time to convert the portfolio into an excel file for cash flow analysis, I've done a few samples, and the NAV yield on individual bonds is phenomenal in many cases. I have to go to my day job now, so I can't finish my report. I'm going to look into becoming an "official" contributor instead, and post it through that channel and my own blog. I do have enough information to at least assuage my own concerns in future pricing. I'm holding my long position, which has a cost basis of $7.16.
Meanwhile, I'd like to see the academic research showing market price moves toward NAV, rather than NAV moving toward market price. No doubt both work together, but you're presuming in PHK's case market price can only go down, and that faster than reinvested dividends can accomodate. Well, you can see from recent history it will drop in price right after ex-dividend, but one doesn't need fundamental analysis to play that game. So there's some good shorting plays just on technical market action.
Meanwhile, the CEF universe is full of WAY under priced funds. I don't see any analyst shouting that we go buy up those deeply discounted funds. Probably because they hold assets that are most likely about to depreciate in a weak market. Which leads me to believe the reality is the market prices CEFs based on expected directional movement in the industry in which they represent. It isn't just a matter of yield, especially when asset prices are mis-priced to begin with. Bonds in this portfolio are clearly mis-priced if the financial world doesn't collapse for good pretty darn quickly
In the case of PHK, given the Federal Reserve's clear intervention and market-making operations, the likelihood that the American economy won't become like Russia's in the next two years (from a consumer's perspective), it is more likely NAV will rise to meet the current price at around 8.50. In fact, 8.50 is still 43% below the 5-year historical NAV of $15. So if one believes in a 5-year recovery of the American economy, and that Pimco knows how to hold bonds reflecting the American economic future, then a purchase today held for 5 years could yield a nice return, especially if the reversion to the mean occurs in less than 5 years.
As a matter of fact, it's already risen $2.48 since March 31. That's a NAV gain of 71% in 4 months. Meanwhile, in those four months, the premium has remained above 50%. How come it's not falling like it should? I think that's your point, the premium should shrink.
Now one should consider this fund's market was severely distressed back in March, so it's not surprising NAV rose quickly as market prices for securities rose. One should not expect 71% gain in NAV the next four months. Low and behold, one can see in the daily chart in fact the spot market is pricing in exactly that likelihood as the price has been range-bound flat for two months now.
What will the NAV be in 6 to 12 more months? I don't know, but I'm confident Ford bonds won't be yielding 25%, financial bonds will rise in value to bring yields closer to 12%, and credit defaults swaps on the big banks with hands in the fed cookie jar will continue to decline. All of these will contribute to rising NAV over time. If the market price stays flat or even falls to no premium, the ROI looks pretty good relative to some other choices.