PIMCO High Income Fund Cannot Support Its Share Price

Recent investors in Pimco High Income Fund (PHK) may not be as dumb as I initially suspected. That honor may be duly shared by Pimco and Bill Gross who may have placed themselves in an untenable position.

Consider the following:

1. PHK’s stock had been underperforming its peer group for several years.
2. Mark Hudoff, PHK’s portfolio manager of six years, was replaced in early 2009.
3. William H. (“Bill”) Gross, the “Bond King” and founder of Pimco, assumed primary responsibility for PHK’s day-to-day portfolio operations in May of ’09.

Query? Why would Bill Gross, a fixed-income investment legend, want to take over a $750 million, inconsequential closed-end fund representing 0.1% of Pimco’s assets under management?

Why not just replace Mr. Hudoff with another garden variety MBA? Would it be reasonable to assume there may have been serious portfolio problems? Would you send for a rocket scientist to fix your leaky faucet?

The 30 Second Meeting: Pimco should have spent more than 30 seconds on this decision. Effectively, the Pimco organization has now relegated the prowess of Bill Gross and possibly the whole Pimco organization, one of the largest fixed-income manager with $750 billion assets under management, to the success of PHK?

What are the implications if PHK were an utter failure? What would it say about the investment prowess of Bill Gross? Implication for Pimco’s other funds?

High Stakes: This seems like there’s pretty high stakes riding on the success of PHK. In fact, this is exactly what investors are counting on! Why else would PHK trade at a ridiculously high distribution yield and an unsustainable premium to NAV? Investors surmise that PHK is now too important to fail.

Lessons from Hillary Clinton’s Successful Commodity Trading: In 1978, Hillary Rodham Clinton invested $1,000 in commodity futures and the investment grew in 10 months into a gain of $100,000. With performance like that, you would wonder why she would ever want to be in the public glare of politics.

Hide the Pea: Her success was essentially an old brokerage shell trading game. Essentially, a brokerage firm places several buy orders; when the orders are eventually matched, the brokerage firm assigns them to the account(s) it desires. In the case of Hillary, she was granted the benefit of the successful trades; the brokerage firm, it “ate” the losses.

Now just suppose you’re the largest bond trading operation in the country. Not only are you managing funds, you’re managing private accounts and more than likely you have proprietary accounts. These proprietary accounts might offer some flexibility in managing net investment income and related distributions of a relatively small, inconsequential entity like PHK.

Cooking the Books? Unlikely, but it does give one pause considering the fact PHK is trading at a 50% premium to NAV—a premium that has not historical been sustainable for a CEF. The only metric supporting the current valuation is its annualized distribution. Based upon the analyses described below, it is very difficult to support that level of distribution with the benefit of public information.

The PHK Challenge: I think it would be a reasonable request for the public relations arm of PHK to issue a supplemental analysis based on publicly available information of how PHK can generate the level of net investment income to support its current distribution level. Supplemental analyses are issued frequently by publicly traded companies when published information is inadequate for a complete understanding of the company.

Candidly, I’d be happy to be proven wrong. It would restore my faith in the contention that private analysis of public data can provide an empirical basis for investing.

The Devil’s Advocate: Pimco’s and Bill Gross' current situation reminds me of the movie Devil’s Advocate. In it, Al Pacino, in his role as the Devil, reminds us, “Vanity, it’s my favorite sin.”

Appendix: I have authored three separate analyses of PHK which conclude: based on publicly available disclosure, PHK can not support its current share price valuation either on its sustainable distribution based on net investment income or its current price to NAV premium. (Reports are available on Seeking Alpha.)

The most recent report entitled “PHK: In Search of the Premium” (8/12/09), which dealt with how the portfolio numbers seem unable to support its distribution level. An earlier report entitled “Pimco High Income Fund (PHK) Still Defying Gravity” (7/22/09), focused on it unusually high premium, and “Pimco High Income Fund: Substantially Over-Valued?” (7/08/09)--based on a peer group analysis.

Disclosure: Short PHK

Comments

[Ron C.:]

Hey Joe, why don't you find another subject to rag on, I think you've beaten this one to death, and some of us actually enjoy the nice monthly dividend this one pays.

Ron C.

Sep 10 12:28 PM

[Joe Eqcome:]

The discounted valuation of which you speak should already be part of PHK’s NAV—depending on the frequency of updating Level II & III assets.

It's would appear to no different when a CEF buys a stock at $10 per share and its price moves to 15; or, if it purchased a highly liquid bond and its valuation increased. Those subsequent price valuations should be part of the current NAV.

In fact, since PHK has such a significant percentage of its portfolio in Level II assets, its own Valuation Committee would in fact be the arbiter of the imputed value of those assets as a component of NAV.

Also, review my article hyperlinked above, “Pimco High Income Fund: Substantially Over-Valued?” that touches on this very issue of valuation.

Joe Eqcome


On Sep 10 11:21 AM User 394898 wrote:

> As of 3/31 the top 10 investments comprised 23% of the fund and averaged
> 8.4% yield to maturity. The questions are, how much was paid for
> the current portfolio and what is the risk of default? If they were
> bought/traded at fire sale prices and defaults prove to be very low
> then the fund could be able to earn the current 14% distribution.
> April 2007 the NAV was at 15.40 and March 2009 the NAV was at 2.81,
> a factor of 5.5 times, so there has been opportunity for improving
> the risk/reward of the portfolio.

Sep 10 12:34 PM

[daved18:]

Have you considered the possibility that the underlying bonds may increase in value as the credit crunch eases and "real "interest rates drop?

I agree that the leverage in PHK is way down, but people are betting on the ability of Gross to pick debt that increases in value as the economy recovers.

PHK was below 3.00 at the depths of the crunch, not a bad return so far.

Sep 10 12:35 PM

[Jade Bond:]

You crack me up Joe. Yesterday's price by my estimation puts your short about 16% in the hole not counting yesterday's dividend charge and today's market, unless your hedging has compensated.

Readers may want to also read en.wikipedia.org/wiki/..., en.wikipedia.org/wiki/..., and "The Disciplined Trader" by Mark Douglas. I just started the section yesterday about how to change one's beliefs to reflect the reality of the marketplace, when the marketplace won't cooperate with one's certain perception of reality.

Someday you might finally be right, Joe. There's good reason to have confidence in statistics. But it's just as plausible NAV will rise and portfolio adjustments bring this fund back to the normative arrangement of high-yield instruments.

I'm sure Gross is having a good time managing this as he uses his understanding and insights in the government interventions and politics of the age to take advantage of the rare opportunities presented to this funds objectives. Something I might add few garden-variety MBAs are likely to grasp or know how to exploit as well as Gross.

Sep 10 01:03 PM

[Joe Eqcome:]

Jade Bond

Your logic is consistent with that of the rating agencies that ignored the facts when it came to valuing sub-prime securities and looked to market’s valuation as a confirmation of their "AAA" credit ratings.

Professional investors like John Paulson, who ignored the chatter, did their analysis, made their bets and waited for the sub-prime market to come unraveled. It probably took longer that one would have anticipated, but it did happen.

Had those investors subscribed to your sentiments they would have ended up like Lehman—as opposed to a billionaire, like Paulson.

This will end badly for new investors chasing yield.

It might even end up badly for older, existing shareholders. Consider the possibility of as a class action suit. If the distribution is dramatically reduced and the share price plunges—which will eventually happen. One could content, that PHK's board had knowingly misled investors by sustaining a dividend they knew was unsustainable; the aggregate share price decline would represent the potential damages.

Even if the suit is remotely winnable it will cost the shareholders litigation expense, a disruption of an audit of the portfolio and the possibilities of a follow-on SEC investigation. This might be a minor distraction.

If you sit by the river long enough everything will eventually float by. I look forward to seeing you bobbing along the way.

I can wait.

Joe Eqcome


On Sep 10 01:03 PM Jade Bond wrote:

> You crack me up Joe. Yesterday's price by my estimation puts your
> short about 16% in the hole not counting yesterday's dividend charge
> and today's market, unless your hedging has compensated.
>
> Readers may want to also read en.wikipedia.org/wiki/...,
> en.wikipedia.org/wiki/..., and "The Disciplined
> Trader" by Mark Douglas. I just started the section yesterday about
> how to change one's beliefs to reflect the reality of the marketplace,
> when the marketplace won't cooperate with one's certain perception
> of reality.
>
> Someday you might finally be right, Joe. There's good reason to have
> confidence in statistics. But it's just as plausible NAV will rise
> and portfolio adjustments bring this fund back to the normative arrangement
> of high-yield instruments.
>
> I'm sure Gross is having a good time managing this as he uses his
> understanding and insights in the government interventions and politics
> of the age to take advantage of the rare opportunities presented
> to this funds objectives. Something I might add few garden-variety
> MBAs are likely to grasp or know how to exploit as well as Gross.

Sep 10 02:27 PM

[Jim Walsh:]

I manage and invest for several portfolios with the objective of income and can find many leveraged Investment Company CEF's that yield 10 to 12% APR today investing in much less risky instruments than PHK does to get 14%. Looking at NAV's in a disfunctional market is folly. If PIMCO does no trades, uses no credit default swaps or hedging, and suffers defaults rates greater than the great depression with no recovery of capital, a Share price of 10.32 might be justified. I think PIMCO is a bit more sophistocated than that!! Bill Gross was chomping at the bit to dive into what he called the opportunitiy of a Century in the fixed income realm. I saw the look on his face. Like a cat that just swallowed a mouse!! My money is on Bill Gross.

Sep 10 04:07 PM

[Jade Bond:]

I didn't see the look on his face, but if I were to speculate like Joe did on a man's motive whom I've never had the chance to ask directly (actually, I am, aren't I?), then I'd guess Bill took over this fund because it was simply the best game in town.

FD: As StockTalk reveals, I sold all my PHK in early August to lock in my gains for the year, not because of Joe's chatter, though. Economic indicators, stocks, bonds, commodities, all suggest either over-priced assets across all classes or horrible inflation right around the corner. Something has to break down soon. Having all that cash in place for another panic is the best position to be in for me. But I wouldn't short anything right now except 30-year bonds. Monetary inflation alone could make everything today a floor of support.

I don't know precisely what will happen, but a good market yield for high-risk bonds in this environment is 12-15%, suggesting PHK is not under-priced. Instead of being greedy for 100% gain, I settled for 50% and will patiently wait for some fright to spoke everyone and provide a new entry point.

I still have standing orders to buy PHK below $9.


On Sep 10 04:07 PM Jim Walsh wrote:

> Bill Gross was chomping at the bit to dive into what he called the opportunitiy
> of a Century in the fixed income realm. I saw the look on his face.
> Like a cat that just swallowed a mouse!!

Sep 10 05:22 PM

[Joe Eqcome:]

Jim Walsh

Let me get this correct. You don’t think that looking at NAVs is a valid metric when investing in a CEF? Then, let me be the first to welcome you to planet Earth!

There are libraries full of academic articles that support the relationship of stock price to NAV. Or, should we just dismiss that and take your word for it.

Let me get you started on this.

A number of studies examine the ability of investors to exploit closed-end fund discounts. In his seminal work, Thompson (1978) uses monthly return data and yearly discount data on 23 funds to evaluate returns from simple trading strategies. He finds closed-end funds trading at a discount tend to outperform the market and concludes that the existence of profitable trading strategies could represent market inefficiencies.

Malkiel and Firstenberg (1978) also offer support for the idea that closed-end funds discounts represent market inefficiencies.

I’d recommend you Goggle, “mean reversion in closed end funds” to “top off” your understanding of this area.

Look, there is nothing wrong with hero worship. So, you think Bill Gross is great. That’s nothing to be ashamed of. A lot of folks thought Bernie Madoff was great too. That’s not to say they are similar. It is just to point out you sometimes need to do the numbers to validate the faith.

Other than that, if you could provide some empirical evidences for your other assertions your comment would be more insightful. Or, should we also take your assertion on faith?

Truly, are you managing public funds? If you are let me know which ones.

Joe Eqcome



On Sep 10 04:07 PM Jim Walsh wrote:

> I manage and invest for several portfolios with the objective of
> income and can find many leveraged Investment Company CEF's that
> yield 10 to 12% APR today investing in much less risky instruments
> than PHK does to get 14%. Looking at NAV's in a disfunctional market
> is folly. If PIMCO does no trades, uses no credit default swaps or
> hedging, and suffers defaults rates greater than the great depression
> with no recovery of capital, a Share price of 10.32 might be justified.
> I think PIMCO is a bit more sophistocated than that!! Bill Gross
> was chomping at the bit to dive into what he called the opportunitiy
> of a Century in the fixed income realm. I saw the look on his face.
> Like a cat that just swallowed a mouse!! My money is on Bill Gross.

Sep 10 05:23 PM

[YoYoMama:]

What does Glenn Beck have to do with this article? First paragraph, good. Second paragraph, completely irrelevant.

On Sep 10 11:17 AM verdae wrote:

> I agree with this article. Why would anyone pay $10.48 for an ETF
> share with NAV of $6.68? And reputations will eventually suffer.
>
>
> A lot of stupid money out there I guess. I had thought that the
> audiences of Glen Beck must be the most gullible people in the world,
> but I think that honor may belong to the owners of PHK.

Sep 10 07:03 PM

[Gruber:]

Why doesn't Pimco do what Joe suggests.

Put out some type of supplemental analysis that substantiates its ability to sustain its annualized dividend based on NII.

This way we can shut Joe up.

Sep 10 08:04 PM

[so1dieroffo...:]

Good work Joe. I'm short PHK as well. I would love to ask Bill Gross in person what he thinks about the premium. If he was honest, he would have to admit that people buying PHK are out of their minds. Buying a portfolio of bonds that trade relatively close to par at 60% premium to its actual market value is insane. I too would like to know which portfolios Jim Walsh manages. I would love to trade with him. I could sell him all the bonds PHK owns - at 60% higher prices than where they trade today. Apparently he likes them at those prices.

Sep 11 02:38 AM

[mavericks:]

I think PHK's premium has much to do with the state of liquidity in the markets. I look at the buy/write CEF's and EVERY one I follow has gone from 20% discounts to premiums...some as high as 30% in just 6 months! It's historically unprecedented as a combination of bank liquidity and small investors looking for income in tough times has moved these CEF's to unsustainable premiums.

That said, I would not be short a monthly pay CEF, particularly one with PIMCO's name behind it. You're basically waiting for a dividend cut, which could be a long wait in a rising market.

Sep 11 08:42 AM

[HunkyDory:]

The only reason I can think of for your mentioning Glenn Beck might be as measurement of naiveté - This being so, I believe you have it back to front. It's not the viewers of Glenn Beck that are naive, rather it's much of the US population and in particular, the so called Democrats. I have a nice bridge for sale....interested?


On Sep 10 11:17 AM verdae wrote:

> I agree with this article. Why would anyone pay $10.48 for an ETF
> share with NAV of $6.68? And reputations will eventually suffer.
>
>
> A lot of stupid money out there I guess. I had thought that the
> audiences of Glen Beck must be the most gullible people in the world,
> but I think that honor may belong to the owners of PHK.

Sep 11 08:59 AM

[gordonq:]

The NAV seems to be telling us that the fund is currently supporting the dividend. The dividend payout decreases the NAV.
6/10/09 5.74
7/10/09 5.70
8/10/09 6.75
9/10/09 6.77

Sep 11 09:11 AM

[HighTower:]

What's the implications of PHK's newly announced investment policy that expands the amount of its portfolio it can investment in investment grade securities?

Doesn't that mean its net investment income will be lower because higher rated bonds yields are lower and the markets are more efficient?

So, now you have lower portfolio income and less leverage? What does that do to investment income?

www.allianzinvestors.c...

Sep 11 11:10 AM

[Joe Eqcome:]

gordonq

There are many factors that constitute a change in NAV.

Your analysis would be accurate if you were to strip out all changes in NAV but net investment income and distributions. This would give you a more precise view of whether or not the distribution is being supported by net investment income.

In fact, approximately 24% of PHK's distribution in July was a return of capital based on their own estimates.

Joe Eqcome


On Sep 11 09:11 AM gordonq wrote:

> The NAV seems to be telling us that the fund is currently supporting
> the dividend. The dividend payout decreases the NAV.
> 6/10/09 5.74
> 7/10/09 5.70
> 8/10/09 6.75
> 9/10/09 6.77

Sep 11 11:21 AM

[searcher:]

Well, Joe, it's pretty obvious that there's a whole lot of folks that aren't impressed with your analysis. Clearly, they're riding with Bill in this satanic vehicle.

Sep 11 08:09 PM

[User 485115:]

I don't own PHK but I do own AOD which is currently selling at a 21% premium to NAV.I'm concerned whether my fund will be able to keep the dividend of $0.12(17.2 % yield) and the funds future?

Sep 11 08:58 PM

[Joe Eqcome:]

You might want to go back and count the comments that were concurring.

The only difference was those who disagreed were more verbose as their ox was being gored. That's entirely understandable.

My only purpose is raise consciousness for those who maybe chasing yield. As I've said, I'd be happy to be proven wrong. It's just no one has been able to demonstrate it empirically.

However, I eagerly look forward to your detailed analytical rebuttal.

Joe Eqcome




On Sep 11 08:09 PM searcher wrote:

> Well, Joe, it's pretty obvious that there's a whole lot of folks
> that aren't impressed with your analysis. Clearly, they're riding
> with Bill in this satanic vehicle.

Sep 12 05:50 PM

[Joe Eqcome:]

Jim Walsh

I want to address your more specific contention that PHK’s valuation is subject to a dysfunctional high yield market. This is the basis of your reasoning that NAV is not a valid measurement during this period of time.

If that were true, the valuation risk should be systematic. All high yield CEFs, as PHK is classified both by the WSJ and ETFConnect, would be subject to this phenomenon. Therefore all such funds should be bias toward a premium. I believe this is not the case.

There are 66 high yield funds in my data base. The average discount is 2.4%. Additionally, the standard deviation (SD) is 9.6%. For the purpose of this example, let’s say 10.0%. All but two of the 66 fall within the 2 SD’s which should constitute 95% of the population.

One of the two falling beyond 2 SD’s that would is Pioneer High Income Trust (PHT) at a 18.3% premium which would place it just a little above the 2 SD of 17.9%.

Therefore, PHK trading at a 47.8% premium is almost 5 standard deviations from the mean. This would mean that PHK has a 0.3% of being part of this peer group.

There are several explanations for this. The first and most popular with your crowd is that Bill Gross has a secret sauce that he will apply to PHK. The second is that PHK is really something other than its classification. The third is Pimco has either a faulty or a superior valuation mechanism relative to its peer group. Or, that it is just plain overpriced.

Let me deal with the possibility that PHK is something else. Recently, PHK announced that it would change it policy reduce it’s 80% holding in high yield to 50% so it would be able to own more rated bonds.

The fact that it has recently changed it investment policy mitigates the contention that PHK’s valuation is a function of a dysfunctional high yield market. Rated paper is more efficiently priced as the markets are more liquid.

Additionally, if you were to now compare it to the CEF fund type “Other Funds” which include high yield funds you wouldn’t be in any better position. Statistically this group’s mean is 1.4% and the SD is 13.7%.

However, PHK would no longer be lonely in the “Other Funds” Group. Because it sister fund PIMCO Global StocksPLUS&Income (PGP) is classified as such. PGP is currently trading at a 63.6% premium. Now, if you just strip out the high yield CEFs in “Other Funds” you’d really get depressed.

So, let’s cut through this. The superior valuations are not a function of a dysfunctional high yield market it’s the “Pimco Effect”. To the extent they can justify these valuation with performance will be played out in the marketplace.

To the extent Pimco can beat these statistical odds it should make them eligible for the Noble Prize in Economics.

Joe Eqcome

On Sep 10 04:07 PM Jim Walsh wrote:

> I manage and invest for several portfolios with the objective of
> income and can find many leveraged Investment Company CEF's that
> yield 10 to 12% APR today investing in much less risky instruments
> than PHK does to get 14%. Looking at NAV's in a disfunctional market
> is folly. If PIMCO does no trades, uses no credit default swaps or
> hedging, and suffers defaults rates greater than the great depression
> with no recovery of capital, a Share price of 10.32 might be justified.
> I think PIMCO is a bit more sophistocated than that!! Bill Gross
> was chomping at the bit to dive into what he called the opportunitiy
> of a Century in the fixed income realm. I saw the look on his face.
> Like a cat that just swallowed a mouse!! My money is on Bill Gross.

Sep 13 11:45 AM