PFL: 7% Dividend That Could Move UP With Inflation

Apr.23.10 | About: PIMCO Income (PFL)

I write primarily about two broad themes for Seeking Alpha. One is US and world markets / economic commentary that I believe will be helpful for Big Picture perspective and investing background. Examples include my series on classic investment books, thoughts on the economy, and in-depth analysis on the workings (or non-workings!) of government and the various broad sectors I have had a few decades personal experience with.

The other broad theme is my never-ending quest for what I believe to be quality companies, closed-end funds, and ETFs that provide excellent total return. In wild and woolly times, these might include growth companies with no dividend payout. But in times when I believe the markets are tired or tiring, I want good solid income to compensate for my expected lack of capital gain.

One such opportunity I am currently pursuing for our clients is the PIMCO Income Strategy Fund (NYSE:PFL), a closed-end fund that currently yields 6.8% on the net asset value (NAV) of its portfolio – but since it sells at a 4.4% discount to NAV, the effective yield is a bit over 7%, paid monthly. Since the average portfolio coupon is 5.9%, you may well wonder if their 6.8% return on NAV is sustainable. I believe it is – they leverage 30% of the portfolio in order to maximize their returns. If they can borrow money more cheaply than the return they receive on the borrowed funds, they believe they may as well do so, at least with 3/10ths of the portfolio.

The fund’s average credit quality is BBB+ -- investment grade, but certainly not crème de la crème. (You weren’t really expecting a 7% yield on AAA paper, were you?!) And the average duration is just 4.3 years, with an average maturity of 3.7 years, so even if this weren’t a “special” situation, you wouldn’t be taking long-term inflation risk with PFL.

But here’s the beauty of this investment: PFL invests in senior floating rate loans, high yield bonds and a smattering of other debt securities. The portion of its portfolio that is in senior floating rate loans means that, as / if interest rates move higher, the interest on these bonds is re-set to reflect then-current interest paid by similarly-rated securities. (I don’t know when rates will rise but, at near 0% for the shortest-term US government paper, I don’t see them declining any time soon to the point where people and nations are paying the US Treasury to allow them to take the risk of holding Treasurys…)

In short, PFL offers high yield, sells at a discount to NAV, and offers at least some protection against inflation. Rather than place our clients and ourselves in a money market fund yielding less than 1%, PFL and other closed-ends holding relatively short-duration and short-maturity bonds make sense for the “cash equivalent” portion of our portfolios right now.

Author's Disclosure: We and / or clients for whom it is appropriate are long PFL.

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