- PIMCO CEFs are known for their large distributions but many are also selling for high premiums.
- The risk-adjusted performances of PIMCO CEFs are not strongly correlated to the amount of premium being paid.
- PIMCO CEFs have a reward versus risk profile more closely aligned with the stock market than with the bond market.
- Over the past 5 years, PIMCO CEFs have handily outperformed the stock market.
- PIMCO CEFs have been about twice as volatile as junk bonds.
As a retiree I have a significant allocation to bond funds and I have been drawn to Closed End Funds (CEFs) due to their above average returns. PIMCO has an excellent reputation for as one of the leading bond management firms but many of their bond CEFs sell at substantial premiums. Since risk is as important to me as return, I wanted to assess the reward versus risk for these funds, where I define risk as price volatility. I understand that not everyone defines risk the same way but this is the definition that works best for me.
Pacific Investment Management Company, LLC, better known as PIMCO, was founded in 1971 and currently has almost $2 trillion under management. The company is one of the world's largest bond investors and is known for its innovative investment strategies, especially the use of derivatives. PIMCO is headed by Bill Gross, who was one of the co-founders and is now the Chief Investment Officer (CIO). Mr. Gross is an award winning manager and is known colloquially as the "bond king". In 2000, PIMCO was acquired by Allianz, a large global investment firm headquartered in Munich, Germany. However, PIMCO continues to operate as an autonomous subsidiary of Allianz.
There are 11 PIMCO Managed CEFs (not counting municipal bond funds) and among these, nine have a history greater than 5 years. These 9 funds are summarized below.
- PIMCO High Income Fund (NYSE:PHK). This CEF sells for a whopping premium of 52%, which is slightly above its 52 week average premium of 46%. This fund is managed by Bill Gross and has about $1.5 billion in assets. The portfolio consists of 286 bonds, partitioned among taxable municipals, Government, corporate, and asset backed bonds. About 54% of the holdings are investment grade. However, it should be noted that this fund is actively managed and may change allocations and durations substantially over short periods of time. The fund utilizes 30% leverage and has an expense ratio of 1.1%. The fund has an extremely high distribution of 11.6%, which consists primarily of income with only a small portion coming from return of capital. The average coupon rate from the bonds in the portfolio is only 6.8%, so how does Gross generate such high returns? He uses a combination of leverage and derivatives to enhance distributions and this strategy has been successful during most years. However, the strategy sometimes runs into trouble, like in 2008 when the price dropped 45%. Also, you should be aware that during market turmoil, the premium may shrink substantially. For example, in 2012, the fund's Net Asset Value (NAV) gained over 40% but the price fell 1.8% because the premium declined sharply near the end of the year (from a premium of 70% to a premium of "only" 20%).
- PIMCO Corporate & Income Opportunities (NYSE:PTY). This CEF sells for a large 19% premium, which is much higher than its 52 week average premium of 14%. Over a 5 year period, the premium has averaged 14.8%, but from time to time has spiked to over 25%. The fund has not sold at a significant discount since a brief period at the end of 2008. This fund is managed by Bill Gross and has about $1.4 billion in assets spread over 269 holdings. The portfolio consists of bonds in multiple sectors including non-agency mortgages, taxable municipals, and corporate debt, with about half the portfolio being investment grade. Gross may make sizable adjustments to the portfolio based on market conditions. The fund utilizes 22% leverage and has an expense ratio of 0.9%. The distribution is 8.5%, without any return of capital. In 2008, the NAV dropped by 23% but the price only declined by 13%.
- PIMCO Corporate & Income Strategy (NYSE:PCN). This CEF sells at a premium of 6.3%, which is close to its 52 week average premium of 6.2%. Over the past year, the premium has been variable, spiking as high as 14% and even dropping to a 3% discount for a short period in August, 2013. The fund is managed by Bill Gross and has assets spread over 222 holdings in asset backed, municipal, and corporate bonds. About 43% of the holdings are investment grade. This fund has about $760 million in assets, utilizes leverage of 22%, and has an expense ratio of 1.1%. The distribution is 8.2%, with no return of capital. During 2008, the fund lost about 20% in both price and NAV.
- PIMCO Income Strategy Fund (NYSE:PFL). The CEF is managed by Bill Gross and sells for a discount of 0.7%, which is about 1% lower than its 52 week average premium of 0.3%. Selling at a discount is relatively rare since over the past 5 years, the fund has sold at an average premium of 5.2%. This fund is focused on floating rate assets, with duration in the low to intermediate range but Gross has the flexibility of varying allocations between fixed-rate and floating-rate bonds. Currently about 58% of the holdings are investment grade. The fund utilizes 22% leverage and has an expense ratio of 1.3%. It is a distribution of 9%, without return of capital. In 2008, the fund lost about 50% in both price and NAV. Last year was not a good year, with the NAV increasing by only 3.7% and the price actually falling by 2.7%. This relatively poor performance is likely why the fund is currently selling at a discount.
- PIMCO Income Strategy II (NYSE:PFN). This CEF is the sister fund to PFL and is also managed by Bill Gross. The fund currently sells for a discount of 1.8%, which is less than its average discount of 0.3%. Over the past 5 years, the fund has sold at an average premium of 3%. In 2010, the fund strategy was revamped to decrease the focus on floating rate loans and enable Gross to invest in a wide range of fixed income assets. Like PFL, the fund duration will normally be in the low to intermediate range. The portfolio holds 196 securities with a total asset value of almost $800 million, with about 54% of the holdings being investment grade. The fund utilizes 21% leverage and has an expense ratio of 1.2%. The distributions 9.1%, with no return of capital. Like PFL, PFN was hit hard in 2008, losing over 50% in both NAV and price. This fund also struggled in 2013, with the price declining by 1%. Over the past 5 years, the price of PFN has been 80% correlated with PFL.
- PIMCO Global StockPLUS & Income (NYSE:PGP). This CEF sells for a tremendous premium of 63%, which is close to its average premium of 57%. Over the past 5 years, the average premium has been 60% but has occasionally dropped to 30%. This fund is managed by Dan Ivascyn, who is Deputy CIO and managing director of PIMCO's Newport Beach office. He leads numerous funds, including a credit hedge fund and a mortgage opportunities fund. PGP is different than many of PIMCO's funds in that it seeks total return by investing in S&P 500 and MSCI EAFE futures as well as bonds. The fund may also employ an equity index option strategy to increase income. The bond portion of the portfolio is focused on asset backed and corporate bonds, with about 37% being investment grade. The fund utilizes 27% leverage and has an expense ratio of 2.6%. The distribution is 9.1%, but about 40% of the distribution is return of capital (ROC). The ROC appears to be non-destructive since the NAV has not eroded but the relatively large negative Undistributed Net Investment Income (UNII) is a concern. In 2008, the fund lost almost 50% in NAV and the price declined by 37%. The fund also had losses in 2011.
- PIMCO Strategic Income (NYSE:RCS). This CEF sells for a premium of 12.8%, which is about equal to its 52 week average premium of 12.2% and is slightly below its 5 year average premium of 15.8%. This fund seldom sells for a discount, the last time being during the 2008 bear market. This fund is managed by Dan Ivascyn and is focused primarily on Government debt. It has assets of $655 million spread over 271 holdings, with almost all in the United States. About 77% of the portfolio is investment grade. The fund utilizes a relatively large 42% leverage and has an expense ratio of 1.4%. The distribution is 9.3%, with no return of capital. This fund lost only 14% in NAV in 2008 and the price actually increased by 2% during that year.
- PCM Fund (NYSE:PCM). This CEF sells at a premium of 7% which is above its 52 week average premium of 4% and is in line with the 5 year average premium of 6.5%. The fund is managed by Dan Ivascyn and focuses on commercial mortgage backed securities and non-investment grade securities. It is relatively small for PIMCO funds, with only $185 million in assets. The portfolio is spread over 206 holdings, with 80% in mortgage backed bonds. About 40% of the holdings are investment grade. The fund utilizes 30% leverage and has an expense ratio of 2%. The distribution is 8%, with no return of capital. In 2008, this fund dropped 40% in NAV and lost 20% in price.
- PIMCO Income Opportunity Fund (NYSE:PKO). This CEF sells at a small premium of 1.2%, which is above the 52 week average discount of 0.1%. Over a 5 year period, this fund has averaged a premium of 3% but has been oscillating around the zero premium line since the middle of last year. This fund has $562 million in assets and is managed by Dan Ivascyn. The portfolio has 375 holdings, allocated primarily among asset backed bonds (59%) and corporate bonds (32%). Only about 30% of the holdings are investment grade. The fund utilizes 25% leverage and has an expense ratio of 1.9%. The distribution is 7.9%, with no return of capital. During 2008, this fund lost a little over 20% in both price and NAV.
To assess these PIMCO funds against the total stock market and high yield bonds, I used the following Exchange Traded Funds (ETF) as references.
- SPDR S&P 500 (NYSEARCA:SPY). This ETF tracks the S&P 500 index, has an expense ratio of 0.09%, and yields 1.9%.
- SPDR Barclays High Yield Bond (NYSEARCA:JNK). This EFT tracks an index of high yield bonds, has an expense ratio of 0.4%, and has a yield of 5.9%.
To analyze these CEFs, I used the Smartfolio 3 program (www.smartfolio.com) with a 5 year look-back period. Figure 1 provides the rate of return in excess of the risk-free rate of return (called Excess Mu on the charts) plotted against the historical volatility
Figure 1: Risk versus reward PIMCO CEFs 5 years.
Figure 1 indicates that there has been a wide range of returns and volatilities associated with the PIMCO funds. For example, PGP had the highest return but also had the largest volatility. Was the increased return worth the increased risk? To answer this question, I calculated the Sharpe Ratio for each fund.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I also plotted a red line that represents the Sharpe Ratio of SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY, which means it has a higher risk-adjusted return than the S&P 500 index fund. Conversely, if an asset is below the line, the reward-to-risk is worse than IEF. Similarly, the blue line represents the Sharpe Ratio associated with high yield bonds.
Some interesting observations are apparent from the plot. Even though PIMCO CEFs are bond funds, they have risk and reward characteristic similar to investing in equities. In fact, with the exception of PKO, the PIMCO CEFs are more risky than the stock market but on the plus side, these funds also generated more returns than stocks. This is pretty amazing considering that stocks have been in a strong bull market over the past 5 years. In terms of risk-adjusted return, all the PIMCO CEFs handily beat the S&P 500 index.
The hybrid Global StockPLUS and Income fund has a volatility almost twice that of SPY but the return was also significantly higher. Since PGP is above the "red line", it can be concluded that the return has more than compensated for the increased risk. However, PGP did not have the best risk-adjusted return over the period. That honor goes to PCM, with PKO being close behind. Both of these highest performing funds were managed by Ivascyn and it is interesting to note that neither of these funds sported extremely high premiums.
Usually, junk bonds, as personified by JNK, are considered to be the highest yielding and most volatile bond class. However, as illustrated by the figure, the risks associated with JNK were mild when compared to the PIMCO CEFs. On a risk-adjusted basis, JNK had excellent performance and actually exceeded the Sharpe Ratio of most PIMCO CEFs. The only CEFs that performed better than JNK were PKO, PCM, and PTY. The performance of PFN and PFL were also similar to JNK.
On a risk adjusted basis, the performance of the high premium PHK came in better than SPY but less than JNK. In fact, the risk-adjusted returns associated with PHK and PGP lagged all the other PIMCO CEFs (except for RCS). Thus, performance of the CEFs does not appear to be highly correlated with the premium being paid.
Since all the CEFs being analyzed are from PIMCO, I wanted to see if you received any diversification by investing in multiple offerings. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the CEFs. The results are provided in the 5 year correlation matrix shown in Figure 2. I was somewhat surprised that, with the exception of the two sister funds PFL and PFN, these CEFs were only moderately correlated. Most of the correlations were in the 30% to 50% range, indicating that you would receive the benefits of diversification if you invest in multiple PIMCO CEF funds.
Figure 2. Correlation matrix over past 5 years
Next I wanted to assess if the outperformance continued into more recent times. I re-ran the analysis over the 3 years from April, 2011 to April, 2014. The results are shown in Figure 3 and what a difference a couple of years makes! The performances of the PIMCO CEFs were still very good but they could not keep up with the rip-roaring bull market in the S&P 500. Only PCM was able to outperform the SPY on a risk-adjusted basis. Note that I only drew the "red line" on this chart since the risk-adjusted performance of JNK was nearly identical with that of SPY.
The CEFs still had performances more aligned with SPY than JNK. Note also that PGP still had one of the best absolute returns among the CEFs but it did so with very high relative volatility, resulting in a relatively poor risk-adjusted performance. As with the 5 year period, PGP and PHK lagged most of the other CEFs on a risk-adjusted basis, illustrating again that risk-adjusted performances were not correlated with the amount of premiums.
Figure 3: Risk versus reward PIMCO CEFs 3 years
The investment landscape became even murkier in the more recent past. Since early last year, the fear of rising rates took its toll on bond funds and the PIMCO CEFs were not immune. To see how these interest rate jitters affected reward versus risk, I re-ran the analysis with a 12 month look-back period. The results are shown in Figure 4. During that period, PIMCO added two new CEFs so I have added the following funds to the mix.
- PIMCO Dynamic Income (NYSE:PDI). This CEF was launched in May, 2012 and currently sells at a 1.3% discount, which is low compared to its 52 week average discount of 5%. The fund is managed by a team that includes Ivascyn. This is a "go-anywhere" fund that invests in global bonds. The fund is large with over $2 billion in assets, spread over 398 securities. The majority of the fund is invested in asset backed bonds (73%) and corporate bonds (20%). About 84% of the portfolio is invested in below investment grade assets and 79% of the holdings are domiciled in the United States. The fund utilizes 45% leverage and has an expense ratio of 2.9%. The distribution is 7.1%, with no return of capital.
- PIMCO Dynamic Credit Income (NYSE:PCI). The CEF was launched in January, 2013 and currently sells at a 5.6% discount, which is slightly above the 52 week average discount of 7%. The fund is managed by a team that includes Ivascyn. This is another "go-anywhere" fund that can invest in a wide range of global fixed income securities. This is a large fund, holding over $4 billion in assets, spread over 514 securities. Most of the assets are corporate bonds (41%), assets backed bonds (27%), and loans (24%). About 59% of the holdings are domiciled in the United States. The fund utilizes 28% leverage and has an expense ratio of 1.4%. The distribution is 8.1%, with no return of capital.
Figure 4: Risk versus reward PIMCO CEFs 12 months
Figure 4 illustrates that, over the past 12 months, the stock market has been king and none of the PIMCO CEFs could keep pace. High yield bonds also performed well and only PDI, PHK, and PGP were able to perform better than JNK on a risk-adjusted basis. Of the CEFs, the new fund, PDI, booked the best performance.
The last year was definitely a tumultuous period for PIMCO, with many funds losing their luster and invincible status. The worst of the selloff appears to have run its course and many of the CEFs are beginning to recover, but some are still below their levels 12 months ago. Could this be a buying opportunity for some of the beaten down PIMCO funds? These funds have typically rebounded from adversity but only time will tell if PIMCO can continue it outperformance. In my opinion, PIMCO is still one of the premier investment houses and their CEFs deserve serious consideration for inclusion in your portfolio.
The PIMCO CEFs are certainly unique in terms of their large distributions and high premiums. The price of a CEF is determined by supply and demand and high premiums are a result of large demand. The PIMCO management team has a strategy that few can duplicate; only a few bond funds can consistently generate such high distributions without resorting to substantial return of capital. Therefore, yield-hungry investors have bid against each other for the opportunity to employ this team and that bidding war has driven up premiums to lofty amounts. Are the PIMCO strategies so unusual that they justify these premiums? Each investor must assess their own risk tolerance to see if PIMCO CEFs fit into their investment plans. Remember that there are no free lunches on Wall Street. High premium CEFs can be good buys for the short term but you should watch them carefully because you will need to exit quickly if the premiums begin to erode. Since performance does not appear to be highly correlated with the amount of premium, my tendency would be to choose CEFs that have relatively small premiums (or even sell at a discount). Among the CEFs, my favorites are PKO and PCM. I also like PDI even though it does not have a long history.