(For those familiar with CEFs, skip to the meat and potatoes section)
For those hungry for yield, there is a great offering by the smart folks at PIMCO, the PIMCO Dynamic Income fund (PDI). This fund has been around for roughly 16 months and in that time it has performed mightily. Since inception, the price of this little pup has risen 10% while the NAV is up over 26%!
This CEF throws off a monthly distribution of $0.177 per share or 7.65% per year. These distributions have been in place since the inception of the fund. However, the best part is that the fund really earns over 9% (and probably over 10%) on its portfolio. Normally, when a CEF significantly outearns their distribution rate, they would increase the distribution. However, in typical PIMCO fashion, they have refused to do so preferring to under distribute earnings.
Unfortunately, CEFs are not required to disseminate the critical information more than every six months. That critical information is: what the current portfolio is earning and what the current UNII level is. [The portfolio earnings are simply the amount of interest the underlying positions are generating. UNII is simply the amount of income that has not been distributed to the shareholders.]
In PDI's case, the latest information we have is from the end of March when the latest annual report on the fund was released. The report requires the investor to do some work in order to get the most relevant information, namely the earnings per share and the UNII. Luckily, we have resources like CefConnect.com that does this in a timely manner for us.
As of March 31, 2013, PDI was earning a whopping $0.32 per share while distributing just $0.177. They also had accumulated $0.44 in undistributed income which will likely come back to us shareholders in the form of a special dividend in mid-December.
The Meat and Potatoes
Analyzing the PDI holdings report which is released monthly with a 30-45 day lag is akin to reading some ancient dead language. But one can glean several high-level items from it. For instance, the fund is overwhelmingly tilted towards mortgages. With 121% of the total assets in some type of mortgage security.
The fund has so much MBS due to it taking an opportunistic approach. It was able to buy significant chunks of this "low-grade" paper at massive discounts to par value. It did so because PIMCO realized that most of the MBS market was hastily downgraded by the NROs to CCC-C ratings in the aftermath of the Great Recession. Most thought the underlying mortgages would all default. Thankfully for investors in this kind of paper, the FED stepped in to support the market plus we had a plethora of government-induced policy that aided underwater and struggling homeowners. Most helpful of all was the decision by most of the large banks to stay foreclosure processes pending the lawsuits and potential errors from processors. This allowed many homeowners to right their finances and catch up to their payments.
Consequently, these investment managers could buy these MBS at ridiculously low prices despite the fact that regular prime mortgages remained in the underlying pools. Some of these MBS were purchased at single-digit cents on the dollar allowing the fund to reap outsized gains when it became apparent that not all the mortgages in the pool were going to default.
One of the apparent alpha-generating aspects of these buys was the fact that some of these MBS may even deserve to be A-rated paper. However, since these securities would surely never reach par again and no one wanted to pay the NROs to re-rate the debt, these securities will remain of the C variety for their perpetuity. PIMCO probably has the best team in the country going out and analyzing the underlying mortgage pools to select the investment grade but C-rated paper.
In general, those Washington Mutual, Countrywide, and Bank of America 2005-2007 vintage mortgages, in other words the worst of the worst, have either defaulted or are paying. And with the collateral on these mortgages increasing thanks to higher prices, they are definitely worth more than the $0.40 on a dollar they were going for, on average, a few years ago.
The above can explain a lot of the NAV rise in the second half of 2012 and early part of 2013. The other aspect is the lower rates and government programs like HARP allowed underwater and otherwise unqualified homeowners to refinance allowing these MBS to appreciate substantially from unexpected prepays. However, since the end of May, we have seen some price erosion, probably due to taper fears and higher interest rates. However, PM Dan Ivascyn has added a twist to his fund. Sometime in the first half of the year, he added a couple of pay-fixed SWAPs to the portfolio.
This is important as the leverage in the fund is in the 45-50% range, and the leverage adjusted duration of the fund 4.36. This is down sharply from early durations of over 10. With these $200m pay-fixed SWAPS, the PM has hedged a significant portion of the portfolio to higher interest rates.
The discount has moved from around par (in line with NAV) to the current 8.3% discount. This not a 52-week low which is 11.3% set a few months ago, but it is well below the 52-week average of 2.5%. This provides a nice margin of safety to new buyers.
The discount has been driven by selling since the May 22 Federal Reserve meeting when tapering was formerly introduced. Since then, the discount has widened substantially with the price down roughly 12% while the NAV is down a more modest 6% accounting for most of the spread widening. This is likely due to the phenomenon of CEF investing where most of the holders are retail and tend to have 'herd mentality'. Selling begets selling. As the price drops, more retail holders look for the exits thereby driving more selling pressure. This tends to make other investors question their positions and consider selling. The downward selling spiral continues until selling is exhausted. The opposite can also happen on the upside and is called 'momentum buying'.
This is evident given that all fixed income CEFs seem to have been trading in tandem as one asset class with the exception being the floating/senior loan variety. At risk here are people throwing out the baby with the bath water.
Given the complexity in valuing a security with the esoteric and sophisticated holdings of a fund like PDI, price becomes the underlying metric focused upon by the typical unsophisticated retail investor and financial advisor, simply because it is obvious.
Between now and the end of the year, an investor can expect two monthly distributions (it's too late to purchase and get the October distribution), one November 1 and the other December 1, each of $0.177/share. The investor can also expect a significant year end special distribution of the undistributed net investment income (UNII).
Undistributed income is likely to be around $0.85/share given the current level and trend. When including the two monthly distributions you are to receive that amounts to roughly $1.20 in income on a CEF price of $27.75, or 4.3%. If you sell on the last day of the year (although you won't get your special distribution until around Jan 20th), the annualized return would be just north of 40%- if the price of PDI does not change over the period.
There is a small chance that PIMCO decides not to payout the UNII but then they face a hefty excise tax. Given they paid out the UNII last year I see no reason they will not do the same this year.
The largest and most widespread concern with a CEF like PDI is the exposure to non-agency paper. The CEF has been in existence for 14 months which has been all during QE-induced markets. Will these non-agency issues get clobbered once the FED stops buying all the agency paper it has been since late 2011?
In general, I view the non-agency rebound as a housing story and not a QE story but there is likely some correlation. How much is not perceivable. The demographics of the buyers of agency and non-agency are completely different with institutional investors looking for the AAA-rated agency paper. Meanwhile, the seasoned non-agency stuff tends to be bought by distressed hedge funds and other pools of "sharper" investors looking for both yield and capital appreciation. Thus, no ALM investors are going to be purchasing the type of MBS that PDI is currently holding.
The other large risk that investors have used to sell or shun investments like this that rising rates are going to decimate fixed income products. While rising rates do mean lower bond prices, ceteris paribus, they may not be the calamity that many think. For one, rising rates mean that PIMCO can reinvest maturing paper into new issues paying higher coupons. Second, as I mentioned before, the PM has initiated some pay-fixed SWAPs worth nearly $200 million. These SWAPs pay the fund a notional value times the rate on LIBOR while the fund pays back a fixed rate times the same notional value. In the end, higher rates mean capital gains on these mark-to-market securities. It also contains IOs (interest-only strips) which, as rates rise, means less mortgages prepay and your IOs last longer paying more in interest over their lives.
Rising rates are going to be indicative of an improving economy should make defaults less likely. This will lead to higher prices on their MBS holdings. The CEF can be really looked at as a distressed housing play with the very smart folks at PIMCO scouring over mortgage pools selecting the best ones for inclusion into their portfolios.
Head Portfolio Manager Dan Ivascyn has been buying this CEF prolifically. Since the start of the fund, he has bought some 370,443 shares as of mid-July. When interest rates spiked recently, he was out buying purchasing 35,997 shares on July 9th and another 30,000 shares on July 16th. He is by far and away the largest shareholder in the fund owning nearly 1% of outstanding shares. It is always a good sign when a fund manager eats their own cooking.
In summation, the CEF PDI contains the following characteristics:
- Distributes 7.8% on monthly basis
- Is currently earning roughly 10+%
- Should receive large year end distribution of UNII
- Has a relatively low levered duration around 4.3
- Contains mostly junk MBS, some CMBS and ABS with a smattering of High Yield and Emerging market debt
- Is trading at a discount of 9%
- Has solid insider buying
- Has a strong management company with a top tier team of analysts behind it
Purchasers are likely to realize outsized gains over the course of the next few months thanks to a host of factors including:
- Retail "herd" selling where the discount potentially closes once momentum shifts
- The large year end distribution
- A great way to play the housing recovery