A lot of discussion in the financial media and market blogs revolves around the Allianz/PIMCO closed-end funds (CEFs) and for good reason. Not only are their fixed income CEFs some of the most popular funds for income investors, but their bond funds trade at some of the highest premium valuations of any CEFs, fixed-income or equity. I even wrote an article earlier this year in February pointing out the extreme valuation differences between the Allianz/PIMCO bond funds and their mostly stock funds. You can read that article here, No Rotation For Allianz/PIMCO Funds.
I thought this would be a good time to update the Allianz/PIMCO CEFs after a spike up in interest rates has mostly affected the fixed-income markets but has also unsettled the equity markets. I should mention that even though all of these funds fall under the Allianz/PIMCO umbrella, their equity funds are typically managed by Allianz Global Investors and their fixed income funds are managed by PIMCO.
The four equity based funds managed by Allianz, the Global Equity & Convertible Income fund (NGZ), the Equity & Convertible Income fund (NIE), the NFJ Dividend, Interest & Premium Strategy fund (NFJ) and the International & Premium Strategy fund (NAI) all include varying percentages of convertible securities except for NAI, which is substantially all foreign stocks. Another major difference between the equity and bond funds is that all of the Allianz managed equity CEFs use an option-income strategy to help pay for their high distributions and yields whereas all of the PIMCO bond funds use a leveraged income strategy. In fact, the PIMCO fixed-income CEFs use some of the highest percentage of leverage of all CEFs.
For those who are unfamiliar with these income strategies, a leveraged strategy is a very aggressive strategy designed to excel in strong up bond and equity markets, depending on the fund's portfolio, whereas an option-income strategy is a defensive strategy designed to excel in flat to trendless up and down markets. Increased volatility helps the option-income funds as well. Certainly, leveraged equity and bond funds have received a performance boost over the last several years as both equity and bond markets have rallied along with lower interest rates and Federal Reserve monetary policies. The question is where do we go from here since it can make a huge difference in the performance and valuations of CEFs.
What I'd like to do is show you the table of all of the Allianz/PIMCO CEFs (bond and equity) that I included in the February article and show the updated market and Net Asset Value prices (far right columns) over the past four months from mid February to mid June.
** Market yield for the Municipal bond funds is adjusted to assume a 35% Federal Income tax bracket.
Here you can see the change in valuations of the Allianz/PIMCO CEFs over the past four months by the change in colors of the Discount/Premium columns. Red designates funds over a 10% premium valuation, green designates funds at a discount and black designates neutral valued funds in between. The equity based funds at the top of the table really haven't changed their discounts that much whereas the real change is showing up in most of the fixed income categories, particularly the Corporate, Government and High Yield, Multi-Sector and Mortgage and Tax-Exempt Municipal sectors.
The Corporate, Government and High Yield PIMCO funds have all gone from lofty premiums to at least more reasonable premiums and yet this has occurred without the fund's NAVs changing that much over the last four months. In other words, the funds have been able to cover their monthly distributions without seeing a deterioration of their NAVs. This goes for the funds in the Multi-Sector and Mortgage category as well, which have mostly dropped to discounts from premiums even though their NAVs have essentially stayed unchanged.
Where the real damage has been done, both on a market price and NAV basis, is in the Tax-Exempt Municipal category where the PIMCO funds have all dropped significantly in price, NAV and valuations virtually across the board. The only exception being the California Municipal Income fund II (PCK).
So is this the start of any rotation in the Allianz/PIMCO funds? Sort of. I wrote this at the end of my article in February in which I reviewed my predictions about the performances of the Allianz equity CEFs from a July 2012 article titled Best Risk/Reward Allianz/PIMCO Funds.
This is what I said...
If one can predict the performances of a small group of equity funds over a relatively short seven months (July 2012 - February 2013) based almost entirely on relative valuations, then investors in the Allianz/PIMCO CEFs should take notice because if there is a rotation out of fixed-income securities, the valuations of their fixed-income funds have a lot more room to fall than their equity funds in my opinion.
This turned out to be correct even if we haven't exactly seen any of the Allianz/PIMCO equity funds show any improvement in their valuations. Could that be next?
Where Is The Real Risk Now In The Allianz/PIMCO CEFs?
Most investors would consider stocks the more risky asset class over bonds but in the case of the Allianz/PIMCO CEFs, this may not be the case. Getting back to the income strategies that these funds use, high use of leverage is going to increase the risk substantially even in bond funds, particularly when bond funds include more risky high yield corporate bonds and mortgage backed securities in their portfolios. Also consider that the effective leverage percentages of the PIMCO fixed income funds above are applied to the total leveraged assets of the fund, not the net common assets of the fund, which would make the leveraged percentages appear even higher.
On the other hand, the Allianz managed equity funds not only use a defensive option-income strategy, i.e. NO leverage, most of the fund's portfolios include from 19% to 27% convertible securities which, as you can see in the table above, is the one category of fixed-income funds that has actually gone up in NAV value over the past four months.
One reason why the Allianz/PIMCO equity funds may not be showing any improvement in their discount valuations is that they include a lot of Return-of-Capital (ROC) in their distributions and most investors are very wary and confused about what ROC represents. Two of the equity funds, NGZ and NAI, include 100% ROC in their distributions according to CEF Connect, whereas NFJ is mostly ROC and NIE is mostly short term realized gains.
Now before you think this is a red flag, it should be noted that option-income funds almost always have a lot of ROC in their distributions because of the way they are managed. In fact, many option-income CEFs try to maximize ROC because of the tax benefits. However, this does not necessarily have to be at the expense of the fund's NAV and funds can be showing lots of ROC in their distributions even while their NAVs are rising. In fact, funds that show their distributions derived entirely from portfolio income (almost always bond funds) may actually be the ones losing NAV value, the true definition of ROC, commonly referred to as "destructive" ROC. More on that in a moment.
Here is a 1-year total return comparison of all four of the Allianz/PIMCO equity funds from June 14, 2012 to June 14, 2013.
Here you can see that even though NGZ, NFJ and NAI all include mostly ROC in their distributions, their 1-year NAV total returns (left highlighted column) easily cover their NAV yields (right highlighted column), resulting in net growing NAVs even after distributions. NIE also would be showing mostly ROC if the fund managers hadn't been taking realized gains, which could just mean that the managers are allowing positions get called away instead of closing out positions before expiration. This is one of the advantages of option-income funds. If the fund managers don't take realized gains in their stock positions and instead manage the portfolios to generate option losses in an up market and equity losses in a down market, then most of their distributions can be classified as ROC, even when the NAVs are growing. The advantage of ROC is that it is not taxable in the year received though investors would need to reduce their cost basis by the ROC amount, effectively deferring taxes until the security is sold.
Now I should also add of the Allianz/PIMCO equity funds, I feel that NIE and NGZ are, by far, more attractive than NFJ and NAI, even though NFJ and NAI have the higher market yields. What trumps higher yields in CEFs is total return NAV and market price performances since that includes all distributions and here, NIE and NGZ show some of the best performances of all option-income funds, not just the Allianz funds. Both NIE and NGZ can sell options against up to 70% of their stock portfolios, which for NIE is a pure US stock based portfolio and for NGZ it's 62% US stocks. NIE also includes 29% convertible securities and NGZ 19% convertible securities as part of their overall portfolios. NIE is also in a position to raise its distribution, since it has an absurdly low 5.6% NAV yield, but I have not been able to get an explanation from Allianz why it has not yet raised NIE's distribution.
On the other hand, NAI, as a pure international stock fund, is the most vulnerable of the equity funds because of its relatively high NAV yield and narrower discount compared to the other funds. In fact, NAI is the only Allianz/PIMCO fund that has cut its distribution over the past year, something that I said would happen in articles from last summer. NFJ is the largest and most well known of the Allianz equity funds at $1.68 billion in assets and is the most defensive as well.
Though distribution cuts in the PIMCO fixed-income funds has been virtually non-existent, which is a big reason for their premium valuations, I'm not sure how long this can last if interest rates continue to rise. Even if PIMCO decides to maintain its uber high distributions and yields, there will be a cost to the fund's NAVs, something that is already showing up in its municipal bond funds. In fact, the PIMCO municipal bond CEFs are already reflecting negative NAV growth this year, which is the true definition of "destructive" ROC even if their distributions are still shown as derived from portfolio income.
Which Allianz/PIMCO Funds Are Really Returning Your Capital?
This is probably the most confusing aspect of Return-of-Capital. If a fund is covering its distribution from portfolio income and yet the fund's NAV is deteriorating, are the distributions ROC? Technically, no. The Alpine equity funds (AOD) and (AGD) were able to get away with this for years. By placing a precedence on harvesting portfolio dividend income over maintaining the fund's NAVs, investors paid lofty premium market prices even while it was clear to authors like myself that this income strategy was a recipe for disaster. Eventually, AOD and AGD were forced to make huge distribution cuts in 2010 and 2013 and the funds currently trade at pretty close to their all-time lows.
On the other hand, I've shown how CEFs with 90% to 100% ROC in their distributions can still be growing their NAVs, which is completely counter-intuitive to the definition. No wonder there is so much confusion on this subject. And Undistributed Net Investment Income (UNII) is not always a big help either.
Take a look at this table of all of the Allianz/PIMCO CEFs and their earnings data, including UNII, as of April 2013.
Here, UNII represents the balance of undistributed income for each fund and you might come away thinking the PIMCO municipal bond funds were in good shape. Perhaps from an income standpoint this is true, but holders of the PIMCO municipal bond CEFs probably don't feel so reassured so far in 2013.
The four equity CEFs - NIE, NFJ, NGZ and NAI - don't even show UNII because they have virtually no net income from portfolio dividends after management expenses. Option-income funds typically have negative UNII because they don't rely on dividend income and instead rely on option-income.
I don't like to venture too far into the fixed-income CEF universe because it is a much more complex arena than equity CEFs. Between heavy uses of leverage and securities that can often be more illiquid, I don't feel comfortable passing judgment on these funds. And I am certainly not going to pass judgment on the PIMCO fixed-income CEFs which have worked so well for so many investors over the years.
However, investors looking for safer and more defensive high yielding CEFs from Allianz/PIMCO may want to start considering their equity funds in light of a rising interest rate environment. Here is a 1-year total return market price performance of NIE (red) and NGZ (dark blue) compared to some of the more popular PIMCO fixed income funds, the Global StocksPlus & Income fund (PGP) (neon green), the High Income fund (PHK) (pink) and the Municipal Income fund II (PML) (light blue). Total return means all monthly or quarterly distributions are reinvested along the way.
Who would have thought that the Allianz equity funds NIE and NGZ, often neglected and unappreciated, would be outperforming the more popular PIMCO funds PGP and PHK and far outperforming all of their municipal bond funds over the past year. Then consider that NIE and NGZ continue to trade at -11.4% and -10.9% discounts respectively compared to PGP at a 47.9% premium and PHK at a 31.9% premium. Now, you tell me which funds are safer.
Note: Though PGP falls under the Allianz/PIMCO equity fund category, PGP is really a highly leveraged fixed-income fund that also owns large positions of S&P 500 E-mini futures.