PIMCO High Income Fund Cannot Support Its Share Price

Sep.10.09 | About: PIMCO High (PHK)

Recent investors in Pimco High Income Fund (NYSE: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